The advantages for participants are readily apparent: "The 401(k) loan is the easiest loan to get in America," says David Wray, head of Profit Sharing/401K Council of America, who notes the average loan balance was $8,619 in 2010. To access the loan, no credit check is involved, and transaction costs are much lower than what's usually paid on a credit card or auto loan or other consumer debt. Most 401(k) loans carry an interest rate about 1 or 2 percentage points above prime.

Wray also adds that numerous studies have shown that having the loan option increases participation in the plans, especially among lower-income workers, who otherwise would never contribute. "Imagine an employer saying, 'Give us your money and you can have it in 30 years,' when this guy's having trouble buying shoes for his kids," Wray points out. "But once you say, 'you can borrow money from your plan if your car breaks down, and we make it easy for you,' that's the incentive."

But financial advisors have long warned about the drawbacks of borrowing from a 401(k). Chief among them are the "opportunity cost" that results when funds are withdrawn and lose their potential to earn investment returns. Because some plans will allow or even require that participants reduce or eliminate new contributions to the 401(k)plan while they  have a loan outstanding, savings take a further hit. Depending on the type of enrollment, ceasing contributions during the loan repayment can erode future retirement income by 10 to 15 percent, according to estimates from the Employee Benefit Research Institute. If two loans are taken, this reduction nearly doubles.

(The EBRI found that if a participant continues to save during the loan repayment period, the loan causes little change to expected retirement income.)

And in a fragile economy with nationwide unemployment  above 9 percent, the fact that most plans require  borrowers to pay off loans in full when they leave a company—typically within 60 days–should also give employees pause. Failing to pay the loan back in time exposes them to a 10 percent penalty (if under age 59 ½) and income tax due on the loan.

The Government Takes Note

Even the federal government is trying to address the leakage from retirement plans with a bill put forth in May that would, among other provisions, limit the number of loans participants can take at one time to three (currently employers determine the number of loans), and extending the repayment time if they are laid off.  View the bill's summary and status here.

On the Other Hand

Surprisingly, an argument in support of tapping 401(k)s in certain circumstances was made in a 2009 paper by Federal Reserve economists Geng Li and Paul A. Smith. They found that, given the lower transaction costs compared with loans from outside lenders, a 401(k) loan could make sense, and devised a checklist of four questions that borrowers might ask themselves to help assess whether the loan is worth considering. Answering  "yes"  to each of the four questions could mean a 401(k) loan is the better option, while even a single "no" suggests looking at other options as well.  They also advocated for allowing participants to repay 401(k) loans gradually, even after separation from their employers. 

1. If you did not borrow from your 401(k), would you borrow that money from some other source (e.g., credit card, auto loan, bank loan, home equity, etc.)?

2. Would the after-tax interest rate on the alternative (non-401(k)) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period?

3. Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions?

4. Are you comfortable with the requirement to repay any outstanding loan balance within 90 days of separating from your employer, or pay income tax and a 10 percent penalty on the outstanding loan?

How to Help Employees

The Aon Hewitt:  Leakage of Participants' DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income report offers guidance on ways plan sponsors can design the loan option to help ensure it's used wisely, and with the best odds for being paid back. Some of the reports's suggestions:

Reduce the number of loans allowed The majority of plans  allow employees to take more than one loan

Allow for loan payments after termination  Only one in five plans allow this, but you can reduce defaults by allowing repayments throughout the loan's term, letting borrowers repay via regular payments from their personal bank accounts

Educate employees  Employees should understand the pros and cons of the loans, and the advantages of continuing contributions. Also useful: offer internet tools that can demonstrate the impact of taking a loan on their future retirements nest eggs

Read the entire report at http://www.aon.com/attachments/thought-leadership/survey_asset_leakage.pdf