worried investor looking at computer.jpg

4 Reasons Not to Borrow From a 401(k)… Especially Right Now

Given the inflated cost of living at this time, it comes as no real surprise that Americans are waist-deep in debt. For perspective, the Federal Reserve reports credit card balances alone reached a record-breaking $1.13 trillion in the final quarter of last year.

Some of these borrowers are recklessly splurging, to be fair — that’s nothing new. Many of these people, however, are just trying to pay for necessities like groceries, transportation, and housing. Indeed, it’s so tough out there right now that mutual fund and brokerage outfits Fidelity and T. Rowe Price both confirm noteworthy upticks in the number of people borrowing from their own 401(k) retirement accounts.

If you’re considering doing the same, do anything else you reasonably can to not do so. Here’s why.

The usual suspects

Yes, you’re allowed to borrow money from your 401(k) retirement savings. Presuming your plan’s administrator permits such loans (and most generally do), in most cases you can borrow up to the lesser of $50,000 or half of your account’s total value.

As is the case with any type of loan, though, such borrowing shouldn’t be taken lightly. There are predictable downsides.

Chief among these impasses is that they aren’t free — you will pay interest on the amount of money you borrow. These interest payments are determined by your plan’s administrator at the point in time the money is borrowed, and are typically based on a marketwide base rate like the prime rate.

Second, the typical payback period on 401(k) loans is five years. You can pay off these loans sooner than that. If you take longer, however, the outstanding balance becomes a taxable distribution of these qualified savings. Depending on your age, this distribution could also incur an age-based penalty for early withdrawal.

And there’s a related catch that’s particularly important to understand, given the likelihood of how long you’ll stay at your current job. That is, if your employment ends before you’ve fully repaid a 401(k) loan, you’ve then got only 60 days to repay it in full. If you don’t, the taxable distribution and potential age-based penalty rules kick in.

Lastly, of course, taking money out of your 401(k) plan means you’re taking money out of the stock market itself. This is a clear opportunity cost. For perspective, given the S&P 500‘s average annual gain of around 10%, $50,000 today could be worth roughly $80,000 five years from now.

The worst possible time for a 401(k) loan

You probably already innately knew all of that (although it never hurts to be reminded). What’s less obvious, however, is that early 2024 is a particularly poor time to borrow money from your 401(k) account.

The interest payments you’ll be making on such a loan are one serious stumbling block. They’ll be high, because market-based rates are high. Most plan sponsors charge between one and two percentage points above the prime rate on 401(k) loans. With the prime rate currently standing at 8.5%, borrowing from your own money from your own retirement account will cost you on the order of 10% per year… the stock market’s average yearly gain.

There’s some good news in this regard. That is, the interest portion of your loan payments is also deposited into your 401(k) account. So, in a sense, you are earning something for lending money to yourself.

These repayments are made with after-tax funds, however, so on a net basis, it’s still a less-than-ideal scenario.

Worried person looking at laptop and holding head.

Image source: Getty Images.

It would also be naïve to ignore the likely reason you’re considering borrowing from your retirement fund in the first place. That’s the sky-high cost of living. This, of course, means it will be financially challenging to make payments on yet another loan.

And that assumes you’ll have a similarly paying job at all in the foreseeable future. There’s an above-average chance you won’t.

Sure, the U.S.’s current unemployment rate of 3.8% is still near the multi-decade low reached in late 2022. There’s more to the story, though. Layoffs are starting to trend higher, while the number of listed job openings has peeled back to about three-fourths of the peak seen in early 2022. To this end, it’s becoming measurably more difficult for job-seekers to get hired. A recent survey performed by staffing agency Aerotek indicated that two-thirds of job-hunters need more time to find their next job than it took to get their last one.

Read between the lines: Your continued employment may not be in dire straits, but it’s not exactly on rock-solid ground either.

Perhaps the top reason you’d want to avoid borrowing money from your own 401(k) at this time, however, is that — despite plenty of economic challenges for people — the economy and the stock market both seem to be performing pretty well. The S&P 500 is up nearly 9% year to date, and higher to the tune of 25% from October’s low. In the meantime, the United States’ first-quarter GDP likely grew at a pace of 2.4%.On a worldwide basis, the International Monetary fund believes global economic growth will roll in at 3.1% this full year before accelerating to 3.2% next year. That’s certainly serviceable, but more to the point, it suggests stocks may very well keep on climbing.

Exhaust all other reasonable options first

Don’t read too much into the message. If you’re about to lose your home or if you need life-saving medical treatment soon and there are no other options, of course you should do what you have to do despite the longer-term financial consequences of the decision.

If there are any other reasonable options like selling a car, however (and maybe even seemingly unreasonable ones like getting a part-time job or starting a side business), you may want to explore those possibilities first at this time. The current economic backdrop is incredibly unique, and must be handled in ways that are just as unique.

The $22,924 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 $22,924 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.

View the “Social Security secrets” »

James Brumley has no position in any of the stocks mentioned. The Motley Fool recommends T. Rowe Price Group. The Motley Fool has a disclosure policy.

Leave a Reply

Your email address will not be published. Required fields are marked *

Related Posts