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When 401(k) Loans Are a Smart Move

After two weeks of volatility in the stock market, and the potential for plenty more ahead, some unlikely winners may have emerged: The growing number of workers who have taken loans from their 401(k) plans recently.

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For years, financial advisers have warned investors not to borrow money from their 401(k) plans, citing lost stock-market gains and the possibility of incurring steep taxes and fees. In many cases, those warnings went unheeded: About one in seven workers borrowed from a 401(k) plan in 2010, with many plans reporting double-digit increases in borrowing.

Some of those workers missed out on significant stock market gains in 2010. But those who have taken loans more recently may not have the same regrets. Many have avoided significant stock market losses, while paying themselves what now looks like a handsome, and guaranteed, rate of return.

By taking a loan before the current market dips, workers essentially locked in some of their gains – as if they’d simply made the decision to sell high, says Olivia Mitchell, professor at the University of Pennsylvania’s Wharton School, who coauthored a study on 401(k) loans. And in addition to preserving principal, these workers are also paying themselves back with interest, in many cases 4.25% (calculated as the prime rate, which has been 3.25% since December 2008, plus 1%), according to the Profit Sharing/401k Council of America. The principal and interest paid back are all deposited into the 401(k) plan.

Meanwhile, as these borrowers repay their loan and re-invest, they’re buying stocks at lower prices, says David Wray, president of the PSCA.

Investors who took a 401(k) loan back in 2007 are in the best stead. They avoided huge losses, which investors who’ve stayed in the market all along have yet to fully recoup. Since 401(k) loans must be repaid in full in five years, they’re now coming to the end of the loan and buying back into the market on the cheap. And because the prime rate was much higher back in 2007, during that year, they were paying themselves interest of up to 9.25%.

Of course, this logic assumes that people who borrowed put the money to smart use – for example, paying off high-interest credit card debt. (A down payment on a house, circa 2007? Jury’s out.) No one could have foreseen any of these benefits, and Wray points out that they’ve occurred at a unique time for the market, one that’s unlikely to be repeated again.

The biggest pitfall of 401(k) loans still looms. If the borrower loses his job, he will have just 90 days to repay the outstanding balance. Otherwise, he will get hit with federal income tax on the outstanding amount plus a 10% penalty if he’s younger than 59 ½ years old.


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