Is it a good idea to borrow from your 401(k)? Some individuals with hefty expenses, like student loans, may consider dipping into these accounts to cover bills or pay off debt. Here are some of the most common reasons why people take loans from their 401(k) and moments when you should (and should not) borrow from your 401(k) balance.
Common Reasons Why People Take Loans From Their 401(k)
Megan Yost, SVP communications at Segal Benz, said there are three primary reasons why people take a loan from their 401(k).
- It’s usually their largest source of savings that they can access.
- They can secure the money in a matter of days.
- It’s a smarter way to get short-term cash than a high-interest loan.
Matthew Compton, managing director of retirement services at Brio Benefit Consulting, said most 401(k) plans also allow a participant to tap into their 401(k) balance without reaching a qualifying event such as a loan or hardship withdrawal. Typically, 50% of a participant’s total balance can be taken via a loan, with a maximum loan amount of $50,000.
“If loans are available, that is typically the better option as it allows the participant to borrow money from themselves and the interest on the loan is applied back to their own balance rather than paid to an outside financial institution,” Compton said.
How Dipping Into Your 401(k) Can Damage Your Financial Security
There are a few disadvantages to taking a loan from your 401(k). Even if it’s a one-time loan, Yost said it can make a dent in the growth of your nest egg.
“One of the biggest issues is that you miss out on the benefits of compound interest, which is when the interest you earn also earns interest,” Yost said.
It’s also important to review the rules of your employer’s 401(k) plan. Depending on these rules, participants may not be allowed to contribute to their 401(k) when they have taken a loan.
Should You Take Money Out of a 401(k)?
Borrowing from your 401(k) does have its silver lining advantages so long as the borrower follows the caveat to repay the money.
“If you can repay it quickly, taking a loan from your 401(k) can actually be a smart move,” Yost said.
Yost uses the example of a person selling house A to purchase house B. They don’t have liquid assets for the down payment today, but they will have the cash as soon as house A closes.
Another scenario in which it may be advantageous to borrow from your 401(k) includes paying taxes owed to the IRS. Drawing from your 401(k) may also work for those going back to school for a higher degree while working as it can be a better approach than taking out student loans.
However, Yost strongly recommends repaying any amount taken out of your 401(k) as soon as possible to avoid defaulting on the loan.
“If you don’t fully repay a 401(k) loan within 60 days, it becomes an early withdrawal and you have to pay a 10% penalty in addition to all the taxes on the withdrawal amount,” said Yost. “The impact of a loan can be truly debilitating to savings, so it should be considered a last resort.”
Compton also recommends only taking out a 401(k) loan if it is absolutely necessary.
“This is retirement money,” Compton said. “When you take a loan out of your 401(k), you are temporarily removing it from your 401(k) account and are not able to take advantage of market returns. If you take a five-year loan and the market is up 30% over that time, you have significantly hurt your retirement savings.”
The better alternative to build financial resilience? Build an emergency savings that you may dip into for necessary funds. Continue saving for your retirement and do not outspend your income.
“If you’re considering taking a loan from your 401(k), take a gut check to see if it’s going to add to your stress, or ease your stress about money,” Yost said. “Psychologically, we’re wired to prioritize the present over the future so it’s hard to resist the pull of our present needs, especially during periods of hardship. But if you have the means to avoid robbing your future self of the money you’ll need then, it will help you in the long run.”
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