Bruce Helmer and Peg Webb
An alarming article in the Wall Street Journal recently reported a growing number of people using their retirement accounts like cash machines — even to cover emergencies. About a quarter of 401(k) account owners who do tap their funds prematurely borrow an average of 11% of their account assets. And even if roughly 90% of those borrowers pay the loans back on time, 1 in 10 will struggle to do so or
simply never pay the money back.
Today’s article discusses why you should always resist the urge to take early withdrawals from your 401(k), either through loans or hardship distributions.
Retirement plans use incentives and penalties specifically designed to keep you from tapping your nest egg until later in life. Contributions to a traditional 401(k) plan are made with pre-tax dollars, meaning if you have a retirement plan at work, you never see the money contributed to your account. It’s deducted from payroll before you get your paycheck.
However, if you take withdrawals from these traditional accounts, the IRS will require you to pay income tax on the full amount, plus often a 10% early withdrawal penalty if you are age 59½ or younger. It’s a strong incentive not to use this money before you retire.
Rules on loans and hardship withdrawals are designed to discourage early withdrawals
Despite the stiff penalties for taking money out early, most 401(k) plans allow you to borrow up to 50% of your vested balance, to a limit of $50,000, and for up to five years. On the surface, it seems like a great deal: Funds can be used for any reason and, because the funds are borrowed and not withdrawn, the loan is tax-free. Even better, you’re allowed to repay the loan gradually — including both principal and interest — and you pay the principal and interest to yourself, often at lower rates than you can get at a bank.
If this sounds too good to be true, it is! We’ll explain why in a minute.
The IRS also allows withdrawals for hardship-related reasons, such as preventing evictions, paying medical and educational expenses, or becoming permanently disabled. Hardship loans are marginally better than traditional loans because they do not need to be repaid. But they do have their own set of rules. For example, the amount of the withdrawal is limited to the amount necessary to satisfy that need. In addition, you’ll be taxed on the amount withdrawn (unless withdrawals are made from after-tax Roth contributions). Finally, you won’t be able to roll the distribution amount over to an IRA or another plan.
The Bipartisan Budget Act of 2018 and SECURE Act 2.0 relaxed some of the rules around taking hardship loans, and that, in part, has made them more popular as sources of emergency cash.
Why taking a loan is not a great idea
From a tax perspective, taking a loan from your 401(k) is inefficient. For one thing, you must pay the loan back with after-tax dollars. This means repayment will cost you more than your original contributions. For example, if you’re in the 24% tax bracket, every dollar you earn to repay your loan leaves you with only 76 cents for that purpose; the rest goes to income tax.
Furthermore, if you take a loan, you lose the earnings on your money while it’s outside the account, creating a huge opportunity cost. If the return on your 401(k) balance is 8% for a year in which you borrowed funds, for example, the effective interest on your loan is 8% — that’s an expensive loan!
Should you lose your job, you’ll have to repay the loan more rapidly — generally by the due date of your next tax return — when you already could be financially vulnerable.
Finally, if you default on the loan repayment, the amount you still owe converts to a withdrawal, and income tax and possible penalties will be due.
The law of unintended consequences
One of the reasons the use of hardship loans has increased is that more employers, to improve retirement security for their workers, are auto-enrolling them into the plans. This means a worker must opt out of their plan if they don’t want to save for retirement. The positive effect is that workers immediately begin to build a nest egg without thinking about it. On the other side, some participants often don’t take the time to understand the rules and penalties that come with participating in a workplace plan and view their 401(k) as a ready source of cash. In fact, according to data from Vanguard, 3.6% of its plan participants took early withdrawals from their accounts in 2023 for financial emergencies, up from a pre-pandemic average of about 2%.
This is not to minimize the very real hardships people were facing. In 2022 and 2023, everyday costs of gas and groceries were going up, and credit card debt began to rise significantly. Nearly 40% of those who took hardship distributions last year did so to avoid foreclosure. More than 75% of hardship distributions totaled $5,000 or less.
In a way, the success that 401(k) plans have recently enjoyed in getting more people to save and invest through auto-enrollment is sowing the seeds of a potential long-term crisis — the retirement savings gap is proving stubbornly difficult to close.
Unless it’s their only recourse, we advise most people against taking a loan from their 401(k). People think they will pay back the loan later, but in our experience, it rarely happens. The tax consequences of paying a loan back with after-tax money erode the value of your hard-earned retirement savings and potentially put you on the sidelines while you service the loan. Moreover, taking a loan could be a red flag that you are living beyond your means and need to consider changes to your lifestyle.
A better approach to the “nuclear loan option” is to build a more liquid emergency fund that will pay for six months or more of living expenses, leaving your retirement fund to build long-term wealth where it’s needed — for your retirement.
Bruce Helmer and Peg Webb are financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on WCCO 830 AM on Sunday mornings. Email Bruce and Peg at yourmoney@wealthenhancement.com. Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment advisor. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.
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