It's not unusual to run into a situation where you need to borrow money. And given where interest rates are today, you may prefer to borrow against your own retirement savings, rather than pursue a personal loan.
If you're housing your retirement nest egg in an IRA, borrowing against your balance generally will not be an option. But some 401(k) plans do allow account holders to take out a loan against their balances.
You might think that borrowing from your 401(k) is a good idea. But a 401(k) loan has the potential to backfire in a notable way.
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The danger of taking out a 401(k) loan
During the fourth quarter of 2023, 2.3% of participants in 401(k) plans borrowed against their savings, according to recent data from Bank of America. And the average loan taken out was in the amount of $8,210.
You might think that borrowing against your 401(k) is a savvy move since you're paying yourself back, rather than paying interest to an outside lender. But there are a couple of big problems with 401(k) loans.
First, if you fail to pay your loan back in time, it will be considered a full-fledged withdrawal. From there, you could face a 10% early-withdrawal penalty if you're not 59 1/2 years old. And if you don't repay your 401(k) loan on time, you won't just face a penalty -- you might also end up seriously short on retirement income.
Let's say you borrow $8,210 from your 401(k) at age 30 and don't pay it back. Let's also assume that your 401(k) averages an annual 8% return, since that's a bit below the stock market's average. Finally, let's assume you wind up retiring at age 67, which is full retirement age for Social Security for anyone born in 1960 or later.
By not repaying that $8,210 loan, you could be short over $141,500 in retirement income by missing out on so many years of lost investment gains in your account. While you can argue that retiring with $8,210 less isn't such a big deal, shorting yourself on more than $141,500 is far more problematic.
Only use a 401(k) loan as a last resort
If you've explored other borrowing options and your only choice for accessing extra money is to take out a 401(k) loan, so be it. But do your best to avoid going this route because of the potential for negative consequences.
Remember, if you're denied a traditional loan but need money, you could try working a side job temporarily to drum up the cash if you need it soon but not instantly. You could also work out an arrangement with a family member who may be in a position to give you a loan. This obviously won't be an option for everyone, but it pays to see if it's available to you.
If you do decide to move forward with a 401(k) loan, read the terms carefully. Pay attention to what happens if you leave your job suddenly, whether due to resigning or getting laid off. In that scenario, your 401(k) loan payoff period could shrink substantially, so it's important to know exactly what risks you're taking when borrowing from your workplace retirement plan.
