Taking out a 401(k) loan can help borrowers pay off immediate debt like credit cards and medical bills. But picking into these savings before retirement may not be the best option, and it could become a repeat move. In fact, more than half (55%) of participants who took at least one 401(k) loan took multiple loans over a five-year period, according to a multi-year study published this year by the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI).
Particularly, workers in their 40s were the most likely to take out a 401(k) loan and the most likely to have more than one loan, according to the research. Over half (59%) of participants in their 40s who took out a 401(k) loan took out multiple loans, compared with 49% of those in their 20s and 41% of those in their 60s.
"In the US retirement system, 401(k) plans are one component of the voluntary retirement plan offerings designed to complement Social Security," the researchers said. "Rising to be the most popular employer-sponsored defined contribution (DC) retirement plan, 401(k) plans have close to $7 trillion in assets, and employers typically design their 401(k) plans to include a range of investment options, employer contributions to promote participant saving, and flexibility of access often through plan loans."
But it's important to understand how 401(k) loans work and to not let it add to accumulating debt.
While many employers allow workers to take out 401(k) loans to cover financial needs like paying off debt, it may not always be the best option.
Eligible 401(k) loan participants can generally take out up to 50% of their savings and up to a $50,000 maximum per year – depending on the specific rules set by the plan, according to a post by Fidelity Investments. But borrowers typically are required to pay that money back into their own plans plus interest within five years. Most plans charge interest rates equal to the Prime Rate plus 1%, according to data from the National Bureau of Economic Research (NBER). And unlike with a standard 401(k) withdrawal, you won’t owe applicable taxes or penalties for taking a 401(k) loan.
The average 401(k) loan balance was $8,550 as of June 2023, according to data from Bank of America.
"Taking a closer look at new loan activity reveals that some 401(k) plan participants appear to be using 401(k) plan loans to meet modest short-term financing needs," Sarah Holden, the senior director of Retirement and Investor Research at ICI, said in a statement. "Indeed, 401(k) plan participants who were observed initiating multiple loans between year-end 2017 and year-end 2020 tended to take smaller loans."
Taking out a 401(k) loan could put strain on your retirement savings if you fail to pay it back under the plan’s terms. But you could consider paying down high-interest debt with a personal loan at a lower interest rate. Visit Credible to compare your options without affecting your credit score.
CONSUMERS ARE TURNING TO PERSONAL LOANS TO PAY OFF CREDIT CARD DEBT: TRANSUNION
If 401(k) loan participants leave their current jobs, they may have to pay back the loan in a shortened time frame. And loans that can’t be paid back under the plan’s terms are considered defaulted. This means borrowers could face taxes as well as a 10% early withdrawal penalty if they’re under the age of 59.5. And some plans won’t allow you to make additional contributions until the loan is paid off, according to a post by Securian. Additionally, 401(k) plan participants essentially pay back tax-deferred dollars using their after-tax money.
And in many cases, alternatives exist. Here are some options.
"Using a 401(k) loan for elective expenses like entertainment or gifts isn't a healthy habit," Fidelity said in its post. "In most cases, it would be better to leave your retirement savings fully invested and find another source of cash."
If you’re struggling with high-interest debt, you don't need to touch your retirement savings to pay it off. You could consider using a personal loan with a lower interest rate to pay down debt. Visit Credible to get your personalized rate in minutes.
CONSUMER CREDIT INCREASED BY NEARLY $5 TRILLION
With inflation rising in August, the cost of living adjustment (COLA) to Social Security benefits could increase 3.2%, according to an analysis by The Senior Citizens League (TSCL). That would bump average monthly payments to $1,847.30, up from last year's average of $1,790. Driven by a 40-year inflation high, the COLA increased to a historic 8.7% in 2023.
The official COLA – which would be announced in October – is calculated using inflation data from July, August and September as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The rates for all three months are added together and averaged before being compared with the third quarter average from the prior year. The official COLA is the percentage difference between the two, which would be reflected in the first Social Security checks sent out January 2024.
But amid ongoing inflation and interest rate volatility, many Americans say they can no longer rely on Social Security. Still, Americans can make the most out Social Security benefits by delaying collection, if possible, until age 70 – when recipients can receive higher payments.
"If you claim Social Security at age 62, rather than wait until your full retirement age (FRA), you can expect a 30% reduction in monthly benefits," Fidelity Investments said in a post. "For every year you delay claiming Social Security past your FRA up to age 70, you get an 8% increase in your benefit. So, if you can afford it, waiting could be the better option."
If high-interest debt is getting in the way of a comfortable retirement, you could consider paying it off with a personal loan at a lower interest rate. Visit Credible to speak with a personal loan expert and get your questions answered.
Have a finance-related question, but don't know who to ask? Email The Credible Money Expert at moneyexpert@credible.com and your question might be answered by Credible in our Money Expert column.
