When you need to borrow money, there are different options you can explore. If your credit is strong, you can seek to take out a personal loan. If you have a home you’ve built up equity in, you can try to borrow against it.
But if you’re sitting on a pretty sizable 401(k) plan balance, then you may be inclined to just borrow money from yourself. Many 401(k) plans today allow participants to take out loans and pay themselves back over time. And at first, this might seem like the easiest route to take when a need to borrow arises.
But while you might think tapping your 401(k) for a loan is a good idea, it’s a move that could sorely backfire on you. Here’s why.
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You’re running a risk
As of the fourth of quarter of 2022, only 2.1% of 401(k) plan participants were borrowing from their retirement savings, according to data from Bank of America. That’s down from 2.3% who had 401(k) loans during 2022’s third quarter. And among those who had an outstanding loan, the average balance was $7,500.
Now if you’re sitting on, say, $500,000 in your 401(k), then taking out a $7,500 loan may not be that big a deal — especially if you have a very short-term need for money and you’re confident you’ll be able to repay that loan quickly. But if you’re sitting on a $25,000 balance in your 401(k), a $7,500 loan has you removing almost one-third of your total balance. And if you don’t end up being able to pay yourself back, you’ll end up shorting your nest egg substantially.
And speaking of not paying back a 401(k) loan — well, if you don’t, the penalties can be huge. Any 401(k) loan that’s not repaid on time gets treated as a 401(k) withdrawal. If you’re not 59 1/2 or older at the time of a 401(k) withdrawal, you get slapped with a 10% penalty on the sum removed from your plan. Plus, any money you end up permanently withdrawing from your 401(k), whether intentionally or not, is money you won’t be able to invest and grow into a larger sum over time.
Also, you might think you’ll have plenty of time to pay back your 401(k) loan. But you should know that if you leave your job — whether voluntarily or due to being laid-off — then your repayment window could shrink to a matter of months. And then, if you can’t pay back your loan by then, you’ll face that dreaded penalty.
Do your best to leave your 401(k) alone
It’s easy to see why a 401(k) loan might tempt you. And if you’re desperate for money and can’t get a loan elsewhere, it may be your only choice.
But do yourself a favor and at least explore other borrowing options before tapping your 401(k) for a loan. While you might think that will be the most seamless, painless way to borrow, you might unfortunately find that the opposite ends up being true.
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