When you need money, you have options. You can go out and apply for a loan or try to leverage the assets you already own. For homeowners, this may mean taking out a home equity loan or a line of credit. For retirement savers, that may mean taking out a loan through a 401(k) plan.
In 2021, 13% of 401(k) plan participants had an outstanding loan, reports Avant-garde. And the average loan amount was about $10,600. While borrowing against your 401(k) may seem like a reasonable decision, 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 borrowing from their accounts. When you repay this loan, you are 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 deciding on one.
For one, the penalties for not repaying a 401(k) loan on time are substantial. In a nutshell, if you don’t repay this loan according to the schedule you are required to commit to, your loan will be treated as an early withdrawal from your retirement plan. At this point, he will be subject to a 10% early withdrawal penalty.
If you borrow from a Roth 401(k), that withdrawal will not be taxable. But if you borrow against a traditional 401(k), you’ll pay taxes on that withdrawal in addition to the penalty.
Plus, while you typically have five years to pay off 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 is true whether you change companies or are fired through no fault of your own.
Finally, if you fail to repay your 401(k) loan, in addition to the penalty and taxes mentioned above, you may find yourself short of retirement savings. Suppose you take out a $30,000 loan on your 401(k) and don’t pay it back. That’s $30,000 less – at a minimum – that you won’t have when your career is over. In reality, you’ll probably be much shorter if you factor in the loss of investment growth on that amount.
Say you take out that $30,000 loan 20 years before you retire. If your 401(k) generates an average annual return of 8% (which is a few percentage points lower than the stock market average), the missing $30,000 will actually equal about $140,000 in lost retirement funds. when you recognize the return you are not get all those years.
Be careful when borrowing from your 401(k)
It’s easy to understand the appeal of a 401(k) loan. But before going that route, it might be worth exploring 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 these options may be a safer bet in the long run.