Retirement is a long time away for most millennials, but sadly many people within this age group are making a risky choice now that could make saving enough for their later years more difficult than it needs to be. That choice: Withdrawing or borrowing money from their 401(k).
A recent report from The Transamerica Center for Retirement Studies found millennials were the most likely of any demographic group to tap into their retirement accounts. In fact, as many as one in three millennial workers has already taken a loan or withdrawn money from their 401(k) or similar retirement plan, or has plans to do so, compared with 15% of Gen Xers and 10% of baby boomers.
And while borrowing or withdrawing from a retirement account may seem like a lifeline for young people coping with the effects of coronavirus, this decision could have far-reaching consequences. Before making it, millennials (and anyone else considering it) need to look at the big picture, including the downsides as well as potential alternatives.
Why tapping a 401(k) for funds is a bad idea for millennials
The Coronavirus Aid, Relief, and Economic Security (CARES) Act has made borrowing or withdrawing from a 401(k) easier. Under the CARES Act, you can take up to a $100,000 coronavirus-related withdrawal without owing the 10% penalty that would normally be assessed for taking money out before age 59 1/2. You can also borrow more than normal, taking a loan of up to $100,000 or 100% of your vested balance, while you're typically limited to the lesser of $50,000 or 50%.
But even though the CARES Act has eased some restrictions on loans and withdrawals, these actions can still have long-term financial consequences. And because millennials have a long time left until retirement, they can actually have an outsize effect.
Say that a 30-year-old millennial investor had $23,000 in a 401(k) (that's the median balance among this age group, according to the same Transamerica report). If that entire amount was withdrawn this year, that investor's retirement account balance at age 65 would be $245,699 smaller than it would've been had the funds remained invested (assuming a 7% average annual return). Missing out on almost a quarter-million dollars in retirement money could be devastating.
And while a loan may seem like a better bet, there are some big risks to borrowing. First, you miss out on gains during the time it takes to repay the loan. And if you time your borrowing poorly, selling during a downturn and not reinvesting your funds until after the recovery, this could mean missing out on substantial gains and earning a lower average rate of return over time.
There's also a chance you may never repay the loan. Not only would this put you back in the situation where you've robbed your future self of a quarter million but you'd also end up owing the 10% early-withdrawal penalty on the defaulted loan. That's true even though the CARES Act would've allowed you to withdraw the money this year without facing this consequence, since a defaulted loan doesn't convert to a penalty-free withdrawal.
There are other alternatives to explore first
Sometimes, borrowing or withdrawing from a 401(k) feels necessary to stave off immediate financial disaster. But before you take money from your future self, be sure to explore all other options first. A 0% APR credit card, a low-interest personal loan, or a home-equity loan could allow you to cover immediate expenses while keeping your retirement funds where they belong.
And although these options do have some costs to them, their downsides should be compared with the risks associated with raiding your retirement plan. A preferred course of action is to make an informed choice about the best way to access cash to see you through hard times.