Considering a 401(k) Loan? What You Can Do Instead

Borrowing from your 401(k) could have a detrimental impact on your future financial health. If you’ve already tapped your 401(k) for a loan, here’s how to recover.

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In a financial landscape marked by soaring inflation and higher interest rates, it's not surprising that a growing number of Americans are turning to their retirement accounts to meet immediate financial needs.

According to a recent report from Fidelity, 2.8% of workers with employer-sponsored 401(k) plans borrowed from their plans during the three-month period from July to September 2023. While it may be tempting to dip into your retirement savings during challenging times, I believe it is important to consider the long-term implications and explore alternative solutions before doing so.

Is borrowing from your 401(k) a mistake?

Borrowing from your 401(k) should be approached with caution, as it may have serious consequences on your long-term financial health. 401(k) plans typically allow participants to borrow up to 50% of their vested funds for up to five years at relatively low interest rates. While this may seem tempting, the possible opportunity cost of no longer being invested in the market may hinder the growth potential of your retirement savings, depending on market conditions.

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When combined with the loan’s interest rate, this could become a significant cost over time. Over the long term, compounding returns can significantly contribute to the growth of your retirement nest egg. Borrowing from your 401(k) could disrupt this compounding process, potentially leaving you with less money in retirement.

Additionally, borrowing from your 401(k) is associated with other drawbacks, such as rapid repayment upon job loss and default consequences. If you lose your job, you may be required to repay the loan by your next tax return. Defaulting is treated as a withdrawal on the remaining amount owed, subject to taxes and possible penalties. Withdrawals from a traditional 401(k) are generally subject to income tax, and if you're under 59½ years old, you may also incur a 10% early withdrawal penalty.

Exploring alternatives: A wiser path forward

Before resorting to tapping into your retirement savings, consider alternative strategies to address financial challenges. Here are a few options worth exploring:

Emergency fund. Building and maintaining an emergency fund can provide a financial safety net during unexpected expenses. Aim for at least three to six months’ worth of living expenses in a liquid and easily accessible account. More is always optimal.

Budgeting and cutting expenses. Evaluate your spending habits and identify areas where you can cut back. Creating a realistic budget could help you allocate funds more effectively and weather financial storms without resorting to tapping into your retirement savings.

Debt management. If high-interest debt is a concern, focus on developing a plan to manage and pay down debt strategically. Consolidating debt or negotiating lower interest rates with creditors could be effective strategies.

Side hustles or additional income streams. Exploring opportunities for additional income, such as a side job or freelance work, could help bridge financial gaps without jeopardizing your long-term retirement savings.

Recovering and planning for your future

If you've already borrowed from your 401(k), it's not the end of the world. Take proactive steps to get back on track and plan for your financial future in retirement. Here are three steps you can take:

Repay promptly. Prioritize repaying the borrowed amount as quickly as possible to minimize the impact on your retirement savings. Check with your plan administrator for the repayment terms and options available.

Increase contributions. To offset the withdrawal, consider increasing your future contributions to your 401(k) once you've repaid the borrowed amount. This can help accelerate the rebuilding of your retirement savings.

Professional guidance. Seek the advice of a financial adviser who can help you navigate the complexities of your financial situation. They can provide personalized guidance and create a plan to help you meet your short-term needs while safeguarding your long-term financial well-being.

In conclusion, while borrowing from your 401(k) may provide temporary relief, it's essential to weigh the potential long-term consequences. Exploring alternative strategies and seeking professional guidance could help you make informed decisions that align with your financial objectives and create a plan designed to help you reach your retirement goals.

All expressions of opinion reflect the judgment of the author, Ken Moraif, as of the date of publication and are subject to change. Ken Moraif is a controlling owner and investment adviser representative of RPOA Advisors, Inc., (d/b/a Retirement Planners of America, “RPOA”), which is an SEC-registered investment adviser. Registration as an investment adviser is not an endorsement by securities regulators and does not imply that ROPA has attained a certain level of skill, training, or ability. Ken Moraif has worked in the financial services industry since 1988. He has been a CERTIFIED FINANCIAL PLANNER™ professional since 1998. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Information presented is intended for educational purposes only. Readers should not rely on the content as the sole basis for any retirement planning decisions. A professional adviser should be consulted and/or independent due diligence should be conducted before implementing any of the options directly or indirectly referenced. Any hyperlinks included this article are provided as a convenience for educational and informational purposes only. RPOA does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether hyperlinked within the article or otherwise incorporated herein, and takes no responsibility for the same.

This article should not be construed as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice. RPOA makes no warranty, express or implied, for any decision taken by any party in reliance upon the information discussed.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Ken Moraif, MBA, CFP®, CRPC®
CEO and Senior Adviser, Retirement Planners of America

Ken Moraif is the CEO and founder of Retirement Planners of America (RPOA), a Dallas-based wealth management and investment firm with over $3.58 billion in assets under management and serving 6,635 households in 48 states (as of Dec. 31, 2023).