(Maurie Backman)
Inflation has created a financial crisis for many people this year. So if you’ve had more trouble covering your living expenses, 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 processing applications with various banks and lending institutions, you may have consulted your 401(k) plan.
If you have your retirement savings in an IRA, you cannot take out a loan against your balance. But many 401(k) plan administrators allow savers to borrow against their balance.
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This may seem like an attractive option, since that money is actually yours. If you have to repay a loan, you repay it to yourself.
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Still, borrowing against a 401(k) can be a dangerous thing for a number of reasons. Fortunately, this practice appears to be on the decline.
loyalty reports that only 2.4% of participants initiated a 401(k) loan during the third quarter of 2023. The percentage of people with an active 401(k) loan was 16.7% – a nice drop from to the 18.7% of savers who had one of these loans during the third quarter of 2020.
If you’re considering taking out a 401(k) loan, know that it’s a decision you may regret bitterly after the fact. Here’s why.
Don’t take risks with your savings
A 401(k) loan may seem like a reasonable way to borrow. But if you fail to repay that loan on time, it could cost you a lot more than expected.
When you withdraw funds from a 401(k) plan before you reach age 59½, 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 as a withdrawal. If you’re not old enough to make a withdrawal without being penalized, you’ll face that 10% hit up front, in addition to being taxed on your distribution. All in all, it’s not a good situation.
Now, if you think you’re being super vigilant and repaying your loan on time, well, that might not happen. If you happen to part ways with your employer while you have an outstanding 401(k) loan, you’ll usually only have a few months to pay it off before treating it as a withdrawal. And you may not be able to meet this deadline.
Also, if you take out a 401(k) loan but don’t put that money back into your retirement plan, you risk a shortfall when your career is over. Remember that you will need a good amount of income apart from Social Security live comfortably after quitting work. So withdrawing a large sum of money from your 401(k) is not a good idea.
If you need to borrow money on the fly, it might be worth considering a personal loan or HELOC, even at today’s higher borrowing rates. And if your loan is for non-essential purposes, such as home renovations, consider waiting until loan rates are more reasonable.
Chances are you’ve worked hard to accumulate a lot of money in your 401(k). So don’t let that effort go to waste by withdrawing some of that money, even if you fully intend to pay it back.
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