How a 401(k) Loan Could Derail Your Retirement Goals
It is becoming more popular to take a 401(k) loan.
A December 2023 report found “more retirement savers have taken loans from their 401(k) accounts over the past year, suggesting that U.S. households are borrowing more readily as they feel the pinch of inflation.”¹
David Blanchett, a certified financial planner and head of retirement research at PGIM, the asset management arm of insurer Prudential Financial, says, “I think 401(k) loans – like credit card debt – are kind of leading indicators of economic stress in America.”²
As Americans struggle to make ends meet, they may need to make tough choices.
One way to ease some of the financial burdens they face: Taking a 401(k) loan.
As Blanchett explains, “Individuals are having to tap their retirement savings because they have to pay for or pay back something.”³
Approximately 138,000 people in this particular study took a loan from their workplace plan in the third quarter of 2023, borrowing an average of $10,778.⁴
While 401(k) loans are an option, it’s important to understand their potential impact before making a decision.
Read on to learn why a 401(k) loan could impact your long-term retirement savings strategy.
The Difference between a 401(k) Loan and a Withdrawal
A 401(k) loan allows you to borrow money from your own 401(k) retirement account, but you must pay it back with interest.
The money you pay back and interest both go back into your 401(k) retirement account.
A 401(k) loan must be paid back typically within 5 years, with interest, and you do not have to pay taxes on the amount borrowed – unless you fail to repay it in the required time frame.
In contrast, 401(k) withdrawals are permanent removal of funds and are subject to ordinary income tax on the amount withdrawn plus a 10% early withdrawal penalty.
For today, we are focusing on explaining 401(k) loans, not 401(k) withdrawals.
401(k) Loan Rules
The first thing to know about 401(k) loans is that not every employer-sponsored 401(k) plan allows participants to borrow from the plan.
You must check first to see if your plan permits 401(k) loans.
Then, you’ll need to determine how much you’re allowed to borrow.
Ultimately, how much you are allowed to borrow is determined by the plan.
According to the IRS, “Generally, if permitted by your plan, you may borrow up to 50% of your vested account balance up to a maximum of $50,000.”⁵
In addition, there are also rules about how much time you have to repay what you borrowed.
According to the IRS, “The loan must be repaid within 5 years, unless the loan is used to buy your main home. The loan repayments must be made in substantially level payments, at least quarterly, over the life of the loan.”⁶
You will also be expected to pay the borrowed money back with interest.
Your 401(k) plan may have additional rules, such as requiring consent from a partner or spouse to take a 401(k) loan.
That’s not all.
Some 401(k) plans prohibit you from making additional contributions until the loan is paid off.
If your plan restricts contributions while a loan is outstanding, it could affect your future 401(k) balance due to missed employer matching and potential investment growth.
What to Know about Leaving a Job with a 401(k) Loan
Another important thing to consider before taking a 401(k) loan is how long you plan to stay with the same employer.
Let’s say you have taken a 401(k) loan and then decide to leave your job or you are fired.
You’ll be expected to pay the loan back by the due date of your tax return in April.
If you do not pay back the full unpaid balance of the 401(k) loan, then it will be treated as an early withdrawal.
Early withdrawals are costly!
If you are under age 59½, you will also have to pay a 10% federal tax penalty on the unpaid balance along with income taxes on the balance of the loan.
If you have to leave a job before you can pay back the loan, you may find yourself in a vicious debt cycle.
[Learn More: What Happens If I Leave My Job with a 401(k) Loan?]
The Personal Consequences of 401(k) Loans
Pulling out money from your 401(k) today for an immediate cash need may hurt your future retirement.
When you dip into your 401(k), you are borrowing from your future.
You may miss out on the potential growth of the money borrowed – and you could end up with less for retirement (even if you follow the rules and pay it back within 5 years).
To show you how powerful compounded growth is to your future, let’s say you have $75,000 in your 401(k), and you don’t tap into your account.
You are 53, and you plan to retire at 68 – or in 15 years.
Even if you stopped contributing any more money to your 401(k) for the next 15 years and you got a 6% return on your money, that money could grow to $179,741.
In this scenario, there has been almost $100,000 growth to your account balance–without you ever contributing another cent.
When you borrow money from your 401(k), you miss out on this type of compounded growth.
[Related Read: 401(k) Loans: Stop Using Your 401(k) as a Bank]
What to Do instead of Taking a 401(k) Loan
If you are struggling financially and know you have money saved in your 401(k) account, it may be tempting to take a 401(k) loan.
A 401(k) loan should be the last resort.
Consider the following options instead.
- Speak to a financial professional. Get an honest take on what borrowing from your 401(k) could mean for your retirement future. Ask for suggestions on how to cover costs while protecting your future.
- Build an emergency fund. Make setting aside emergency savings a goal. If you have money ready for financial emergencies, you won’t have to borrow from your 401(k).
- Cut expenses. If you are considering a 401(k) loan because you can’t make ends meet, instead of taking a loan, cut back on your expenses. Downsize, eliminate unnecessary spending, and stick to a budget.
Find out what 401(k) Maneuver may do for your retirement account balance. Click below to book a complimentary 15-minute 401(k) Strategy Session with one of our advisors today.
Sources
- https://www.cnbc.com/2023/12/10/more-americans-take-401k-loans-an-indicator-of-financial-stress.html
- https://www.cnbc.com/2023/12/10/more-americans-take-401k-loans-an-indicator-of-financial-stress.html
- https://www.cnbc.com/2023/12/10/more-americans-take-401k-loans-an-indicator-of-financial-stress.html
- https://www.cnbc.com/2023/12/10/more-americans-take-401k-loans-an-indicator-of-financial-stress.html
- https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules
- https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules
