Inflation has created a financial crunch for a lot of people this year. So if you’ve had a harder time covering your living costs, you’re in good company.
In fact, you may have reached the point where you needed a loan this year. And if so, rather than dealing with applications at various banks and lending institutions, you may instead have looked at your 401(k) plan.
If you have your retirement savings in an IRA, you can’t take out a loan against your balance. But many 401(k) plan administrators do allow savers to borrow against their balances.
That might seem like an appealing option, since that money is actually yours. If you have to pay off a loan, you’re paying it to yourself.
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Still, borrowing against a 401(k) can be a dangerous thing for a number of reasons. Thankfully, that practice seems to be on the decline.
Fidelity reports that only 2.4% of participants initiated a 401(k) loan during the third quarter of 2023. The percentage of people with an outstanding 401(k) loan was 16.7% — a nice drop from the 18.7% of savers who had one of these loans during Q3 2020.
If you’re thinking of taking out a 401(k) loan, you should know it’s a move you might sorely regret after the fact. Here’s why.
Don’t take chances with your savings
A 401(k) loan might seem like a reasonable way to borrow. But if you don’t manage to pay that loan back in time, it could end up costing you a lot more than anticipated.
When you remove funds from a 401(k) plan before reaching age 59 1/2, you face a 10% early withdrawal penalty, plus taxes on your distribution. If you don’t repay a 401(k) loan on time, it will be treated like a withdrawal. If you’re not old enough to take a withdrawal without being penalized, you’ll face that 10% hit off the bat, plus get taxed on your distribution. All told, that’s not a good situation.
Now if you’re thinking you’ll just be super vigilant and repay your loan on time, well, that may not happen. If you happen to separate from your employer while you have a 401(k) loan outstanding, you’ll usually get just a few months to pay it off before having it treated as a withdrawal. And you may not be able to meet that timeline.
Also, if you take out a 401(k) loan but fail to put that money back into your retirement plan, you’ll risk a financial shortfall once your career comes to an end. Remember, you’ll need a fair amount of income outside of Social Security to live comfortably once you stop working. So pulling a chunk of money out of your 401(k) isn’t a great idea.
If you need to borrow money in a pinch, it could pay to consider a personal loan or HELOC, even at today’s higher borrowing rates. And if your loan is for a non-essential purpose — for example, home renovations — consider holding off until borrowing rates are more reasonable.
Chances are, you’ve worked hard to sock away a pile of money in your 401(k). So don’t let that effort go to waste by pulling out a chunk of that cash — even if you have every intention of repaying it.
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