Things to know before taking a 401(k) loan

A 401k loan, or borrowing from your 401k, may sound like a great idea, but there may be other options. Discover what to know before taking a 401k loan here.

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Key takeaways

  • Taking out a 401(k) loan can undermine your savings and potential investment growth. 
  • If you must take a 401(k) loan, don't stop saving for retirement. 
  • To help avoid the need to borrow in the future and get your finances on track, consider budgeting, building up an emergency fund, and cutting back on credit card debt.

Bumps in the financial road are normal. And when you need extra money, it can be tempting to turn to your largest pool of savings—which is probably your workplace retirement plan—for cash. But that could be a costly choice: After all, your retirement savings account is a vehicle designed to help you accumulate and grow your retirement savings, so reducing it runs contrary to its purpose. Here are a few things to keep in mind before taking a loan from your 401(k) or other workplace account.

You won't be fully invested while you have an outstanding loan balance.

One of the advantages of a 401(k) loan over other types of borrowing is that you pay yourself back with interest. One downside is that the interest may not keep pace with the potential investment return. You may miss out on potential market growth and investment compounding while some of your loan balance is outside the account and not invested.

Over the long term, that can have an impact on the amount of money you have at retirement.

If you leave your job, you may have to pay the loan back in full quickly.

When you take a loan, you may not have any intention of leaving your current employer. But you never know what can happen.

Once you leave your employer, you may be required to pay the loan back in full or the outstanding balance will turn into a withdrawal—and that means your withdrawal will likely be subject to income tax as well as a 10% early withdrawal penalty.

Saving is crucial, even if you take a loan

We understand—loans happen. But after you take a loan, it's important to keep an eye on your long-term goals, and do what you can do to keep saving even while paying back the loan. Slowing or stopping the rate at which you're able to save may ultimately have a bigger negative impact on your retirement savings than the loan itself. Check with your plan administrator to see how your company handles loans—in some cases, any payments you make are considered loan repayments instead of contributions, which means you may not qualify for the company match as well.

Consider the evidence: 401(k) participants who take loans are more likely to reduce or stop contributions than someone who does not take a loan. A Fidelity analysis of 401(k) loans has found that a quarter of participants who take a loan reduce the amount they're saving for retirement in their workplace savings plan, and 15% stop their contributions completely within 5 years of taking a loan. About 1 in 5 people who take a loan decrease contributions in the first year after the loan is taken.*

There is good news, though. People do bounce back from 401(k) loans: 15% of people who take a loan actually increase their contributions while their loan is outstanding.*

Now may be a good time to review your financial situation and create a plan for the future, in order to avoid having to take out a loan.

Read Viewpoints on How to pay off debt—and save too

Multiple plan loans could spell trouble

Taking one loan, one time isn't necessarily going to wreck your retirement.

But once you've taken out one loan it may be tempting to go back a second and even a third time. To try to avoid frequent 401(k) loans, consider these 2 tips for (hopefully) smooth financial sailing:

1. Try not to accumulate credit card debt.
Credit card debt is cited as the top reason people take a loan (31%), according to a Fidelity analysis of 401(k) participant behavior.

When you don't have cash on hand, it's all too easy to fall back on plastic to fund daily purchases. And your balance can snowball over time.

2. Build an emergency fund.
Consider saving enough to cover 3 to 6 months of essential expenses. It can sound like a daunting amount to save all at once, but treat it like a regular bill you pay automatically every month, to help get there over time.

Having a solid cushion of cash for something unexpected can help you avoid using credit cards when you don't have enough cash. It is also invaluable in worst-case scenarios like a job loss, home and car repairs, or illness.

Keep saving

Saving money is a skill and a discipline—it takes practice. Don't despair if you do take a loan from your retirement account, but do consider taking steps to mitigate the need in the future. Establishing an emergency fund and continuing to save in your retirement accounts are great ways to build up your savings muscles.

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