Personal Finance

Don't Take a 401(K) Loan Before Understanding These 5 Factors

Kristin Hitchcock

Published: December 5, 2024 11:15 am

A 401(k) loan might seem like an easy fix if you need cash. However, it isn’t a decision we typically recommend. Borrowing from your retirement savings can have a huge impact on your long-term financial health. 

Before tapping into your 401(k), consider these critical factors to avoid derailing your retirement plans.

24/7 Wall St. Key Points

• A 401(k) loan might seem like a convenient solution, but the long-term risks often outweigh the short-term benefits.
• There are tons of potential downsides to taking out a 401(k) lean, like reduced growth and potential penalties if you don’t repay quickly enough. 
• Also: Take this quiz to see if you’re on track to retire (Sponsored)

1. Long-Term Growth Loss

Your 401(k) grows through compound interest, which requires both time and money to maximize. When you borrow from it, you reduce its overall balance, slowing the growth. Just taking a little bit of money out can be a lot of money a decade later. Dave Ramsey believes that compound interest is how rich people stay rich, so it isn’t something to overlook. 

Repayments don’t fully make up for this lost time, either, especially if the market performs particularly well during the loan period. 

2. Penalties and Taxes Risk

If you fail to repay your loan, the outstanding balance may be treated as a withdrawal. This can trigger:

• Income Taxes: The unpaid amount is added to your taxable income, which can lead to a significant amount of taxes. 
• Early Withdrawal Penalties: When you withdraw money from your 401(k) early, you’re subject to a 10% penalty. Therefore, you’ll have to pay back even more if you don’t make repayments. 

3. Impact on Retirement Readiness

Borrowing from your 401(k) might solve your issues today, but it will make it harder for you to retire comfortably later. 

While you’re repaying your loan, you’re essentially pausing the growth of your retirement account. Over time, this gap can have a huge impact on your total retirement savings, especially when you consider your compound interest. 

If your employer offers matching contributions and you reduce or stop your own contributions to repay the loan, you’re leaving free money on the table. This isn’t something you can make up later. 

These setbacks can force you to save more aggressively later or even completely delay your retirement. 

4. Repayment Challenges

Repaying a 401(k) loan isn’t always straightforward, and certain circumstances can make it particularly difficult.

For instance, if your job changes, most plans require you to quickly repay the entire loan in a very short timeframe, sometimes within 60 days. This is true even for layoffs. If you don’t repay the loans, the same problems that we discussed earlier apply!

Loan repayments are often directly deducted from your paycheck. This reduces your take-home pay and can lead to more financial strain. You may have a harder time paying everyday expenses. 

While you might be able to comfortably handle repayments today, that doesn’t mean you’ll be able to handle them tomorrow. Many of the circumstances that allow you to repay the loan comfortably are out of your control. 

5. Market Volatility Amplifies Losses

When you borrow from your 401(k), you’re taking money out of the market. This causes you to miss out on gains beyond the money you took out for the loan. If it’s a period of strong performance, this is even more dramatic!

Even after repaying the loan, it may take years for your account to recover to where it would have been without the loan due to the compound interest. 

It doesn’t matter your age. This risk is always significant. If you’re closer to retirement, you’re missing out on key dollars. When you’re younger, you’re missing out on tons of compound interest, which can easily add up to tens of thousands more by retirement age. 

Alternatives to a 401(k) Loan

So, what can you do before taking out a 401(k) loan? Well, there are tons of options that may be able to address your financial needs without taking all of these risks:

• Emergency Savings: If you have a rainy-day fund, this should be your first resource for unexpected expenses.
• Personal Loans: While not the best option, when obtained at a reasonable interest rate, this option doesn’t risk your retirement savings.
• Lines of Credit: Credit cards aren’t the best option, as they can incur high interest. However, they are better than a 401(k) loan.
• Credit Counseling: Financial counselors can help you find solutions that don’t require you to take out a loan. Sometimes, making budgeting adjustments or debt restructuring is enough!

When in doubt, we highly recommend speaking to a financial advisor. There are some cases where a 401(k) loan might make sense, but these situations are few and far between. Only a financial advisor can look at all your finances and give you personalized advice.