There may come the point in your life when the need to borrow money arises, whether to pay off medical bills or tackle a massive automobile repair. And at that point, you have options. You could attempt to borrow against your home equity or take out a personal loan if you don't own a home. But if you have money set aside for retirement, you may be inclined to just borrow from your own savings instead.
After all, that money is yours, so rather than pay interest to a lender, aren't you better off repaying yourself?
But tempting as it may be to take out a loan against your 401(k) plan, it's a move you might sorely regret. And thankfully, 401(k) loans seem to be on the decline.
Fidelity reports that during the second quarter of 2022, only 2.4% of 401(k) plan participants initiated a 401(k) loan. And the percentage of participants with an outstanding 401(k) loan fell to 16.7% -- a nice drop from 18.9% during the second quarter of 2020.
Why you shouldn't resort to a 401(k) loan
Taking out a loan against your 401(k) might seem like a good idea in theory. But in practice, it could backfire. If you don't manage to repay your loan on time, it will be treated as an early 401(k) plan withdrawal. And that means you'll face a 10% penalty on the sum you remove, plus taxes if you have a traditional 401(k).
Now you may be thinking, "Well then, I'll just make sure to repay my loan on time." But if you end up losing your job or quitting to take another one, your repayment timeline could end up getting whittled down to just months, depending on your plan's rules. As such, getting stuck with an early withdrawal isn't out of the question.
Furthermore, if you take out a 401(k) loan and don't repay it, you'll have that much less money on hand once your retirement actually rolls around. And remember, you won't just be missing the sum you remove from your savings. You'll also lose out on growth on that money.
So, let's say you wind up taking a $10,000 loan from your 401(k) that at age 30 effectively becomes a withdrawal because you didn't pay it back on time. If you don't retire until age 67 and keep your remaining savings invested at an average annual 8% return during that time (which is a bit below the stock market's average), you'll end up losing out on a total of $172,800 when you factor lost growth into the equation.
That's why a 401(k) loan really should be your last resort and why fewer people having one during 2022's second quarter is a good thing. Borrowing from your own funds might seem like a reasonable solution when a need for money arises. Unfortunately, 401(k) loans can backfire in a very serious way -- compromising the comfortable retirement you've been working so hard to save for and enjoy.