13% of 401(k) Participants Borrowed Against Their Plans in 2021 — Here’s Why That’s a Dangerous Move

When a need for money arises, you have options. You can go out and apply for a loan or try tapping the assets you already have. For homeowners, that can mean taking out a home equity loan or line of credit. For retirement savers, it can mean taking out a loan against a 401(k) plan.

In 2021, 13% of 401(k) plan participants had a loan outstanding, reports Vanguard. And the average loan amount was about $10,600. While borrowing against your 401(k) might seem like a reasonable move, it’s one that could easily backfire.

The dangers of 401(k) loans

It’s easy to see why 401(k) plan participants are drawn to borrow against their accounts. When you pay back that loan, you’re repaying yourself, as opposed to a bank or lending institution. But 401(k) loans can be dangerous, so it’s a good idea to explore other options before moving forward with one.

Image source: Getty Images.

For one thing, the penalties for not repaying a 401(k) loan on time are substantial. In a nutshell, if you don’t repay that loan as per the schedule you’re required to commit to, your loan will be treated as an early withdrawal from your retirement plan. At that point, it will be subject to a 10% early-withdrawal penalty.

If you’re borrowing against a Roth 401(k), that withdrawal won’t be taxable. But if you’re borrowing against a traditional 401(k), you’ll pay taxes on that withdrawal on top of the penalty.

Furthermore, while you’ll generally get five years to repay a 401(k) loan, if you stop working for the company sponsoring your plan, you’ll have to pay back what you owe much sooner — usually within 90 days. This holds true whether you switch companies or get laid off through no fault of your own.

Finally, if you don’t manage to repay your 401(k) loan, in addition to the penalty and taxes mentioned above, you might short yourself on retirement savings. Say you take a $30,000 loan from your 401(k) and you don’t repay it. That’s $30,000 less — at a minimum — that you won’t have available once your career wraps up. In reality, you’ll probably be short a lot more when you factor in lost investment growth on that sum.

Let’s imagine you take out that $30,000 loan 20 years ahead of retirement. If your 401(k) generates an average annual return of 8% (which is a few percentage points below the stock market’s average), that missing $30,000 will actually amount to roughly $140,000 in lost retirement funds when you account for the return you aren’t getting all those years.

Be careful when borrowing against your 401(k)

It’s easy to understand the appeal of a 401(k) loan. But before going that route, it could pay to explore other options. You may be able to borrow against your home or qualify for a personal loan if you have good credit. And both of those options may be a safer bet in the long run.

The $18,984 Social Security bonus most retirees completely overlook
If you’re like most Americans, you’re a few years (or more) behind on your retirement savings. But a handful of little-known “Social Security secrets” could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $18,984 more… each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we’re all after. Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.

Leave a Reply

Your email address will not be published.