Good news – Fewer savers made that dangerous 401(k) move last quarter

(Maurie Backman)

Inflation has created a financial crisis for many people this year. So if you’re struggling to make a living, you’re in good company.

In fact, you may have reached the point where you need a loan this year. And if so, instead of dealing with applications at various banks and credit institutions, you may have turned to yours instead 401(k) plan.

If you have your retirement savings in an IRA, you cannot borrow against your balance. But many 401(k) plan administrators allow savers to borrow against their balance.

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This might seem like an attractive option since that money is actually yours. If you have a loan to pay off, pay it off to yourself.

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Still, borrowing against a 401(k) can be dangerous for a number of reasons. Thankfully, this practice appears to be on the wane.

loyalty reports that only 2.4% of participants initiated a 401(k) loan in the third quarter of 2023. The percentage of people with an outstanding 401(k) loan was 16.7% — a nice drop from the 18.7% of savers who had one of those loans in Q3 2020.

If you’re thinking of taking out a 401(k) loan, know that you may regret it later. Here’s why.

Don’t take any chances with your savings

A 401(k) loan seems like a reasonable way to borrow money. But if you don’t manage to repay that loan on time, it could end up costing you a lot more than you expected.

If you withdraw funds from a 401(k) plan before you reach the age of 59 1/2, you will face a prepayment penalty of 10% plus tax on your distribution. If you don’t repay a 401(k) loan on time, it’s treated like a payout. If you’re not old enough to make a withdrawal without being penalized, expect that 10% upfront, plus tax on your withdrawal. All in all, this is not a good situation.

Well, if you think that you’re just going to be super vigilant and pay off your loan on time, well, that can’t happen. If you happen to part ways with your employer while you have an outstanding 401(k) loan, you typically only have a few months to pay it off before it’s treated as a payout. And you may not be able to keep that schedule.

Even if you take out a 401(k) loan but don’t put that money back into your retirement plan, you risk finding yourself stuck financially when your career comes to an end. Remember that you need a fair amount of outside income social insurance to live comfortably when you stop working. So pulling a bunch of money out of your 401(k) is not a good idea.

If you need to borrow money in a pinch, it may be worth considering a personal loan or HELOC, even with today’s higher lending rates. And if your loan is for a nonessential purpose — like home renovations — consider waiting until lending rates are more reasonable.

Chances are you’ve worked hard to put a bunch of money into your 401(k). So don’t let those efforts go to waste by pulling out some of that money — even if you intend to pay it back.

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