Retirement savings are supposed to help you cover your expenses after you leave the workforce, but sometimes you can't wait that long. More than a quarter of workers have taken a 401(k) loan at some point, according to a recent Transamerica survey.
This can get you the cash you need in a hurry, and it might be preferable to taking out a high-interest loan. But it can also put your long-term financial security at risk. If you've taken a 401(k) loan recently, here's the best thing you can do for yourself right now.
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How a 401(k) loan works
A 401(k) loan is a loan you take from yourself. Not all plans allow them, but if yours does, you can borrow up to the lesser of 50% of your vested account balance or $50,000. There's no credit check, so this can be an appealing option for those without emergency savings who believe they'd struggle to borrow money elsewhere.
But a 401(k) loan is still a loan. You must pay back the amount you withdraw over time, plus interest, or else the government considers the outstanding balance to be a distribution. You'll pay taxes on it then in the year the loan term ends, plus a 10% early withdrawal penalty if you're under 59 1/2. And if you leave your job, the full balance of your 401(k) loan could become due immediately.
More importantly, taking money out of your 401(k) slows the growth of your savings. When your money isn't invested, it can't grow as quickly. So you'll have to set aside even more money per month going forward to retire on your original schedule. Or you might have to delay your retirement.
What to do now
It's best to weigh all your options before taking a 401(k) loan. Using emergency savings or taking out a bank loan could be a better fit than draining your retirement account. But if you've already taken a 401(k) loan or you believe this is your best option, make repayment a top priority.
Talk to your employer or 401(k) plan administrator to learn about the terms of your 401(k) loan, including how long you have to repay it, what the interest rate is, and how often you'll have to make payments. You should also ask about how you can make repayments. Some employers require you to do this through automatic payroll deductions.
You may have to make some changes to your budget moving forward in order to afford the loan repayments. Once you know what your repayment schedule will look like, you can begin to plan these out. You might have to cut back on discretionary purchases or consider working overtime for a little while to get the extra cash you need.
Do your best to stay on top of your payments even if you don't think you'll be able to pay back the full balance in time. The more you're able to pay back, the less you'll owe taxes and penalties on.
And regardless of whether you pay back the full balance or not, it's a good idea to review your retirement savings strategy after the loan term ends. Look at how much you currently have in your retirement accounts and then estimate how much you need to save in order to retire when you originally planned. Update your monthly savings target as necessary or consider pushing your retirement date back a little to give yourself additional time to prepare.
