There are a number of ways that 401(k) plans differ from IRAs. With a 401(k), your retirement plan is funded through payroll contributions. And you may be eligible for some type of employer match.
IRAs, on the other hand, are self-funded, and so there are no matching incentives involved. IRAs also come with much lower contribution limits than 401(k) plans. However, on the plus side, IRAs allow savers to invest their money in individual stocks, whereas 401(k) plans generally limit savers to a bunch of different funds.
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Another difference between 401(k)s and IRAs is that with the latter, you really don't get the option to borrow against your long-term savings. On the other hand, many 401(k) plans do allow savers to borrow against their balances and repay those loans over time.
Recent data from Fidelity shows that 401(k) loans are on the rise. But that's actually not a good thing at all.
The danger with 401(k) loans
Fidelity reports that during the third quarter of 2023, 2.8% of participants took a loan from their 401(k). That's up from 2.4% of savers doing the same during the third quarter of 2022. All told, the percentage of workers with a 401(k) loan has increased modestly to 17.6%, up from 16.8% during the third quarter of 2022.
Why is that a bad thing? While borrowing against a 401(k) might seem like a good solution when a need for money arises, it can actually be quite a dangerous thing. That's because failing to repay a 401(k) loan could have harsh financial consequences.
In a nutshell, 401(k) loans that aren't repaid in time are no longer considered loans -- they're considered withdrawals. And that could be very problematic if you take out a 401(k) loan before age 59 1/2. That's because withdrawals taken prior to 59 1/2 are subject to a 10% penalty with very limited exceptions.
So to put it another way, if you fail to repay $10,000 of a 401(k) loan, you may be penalized to the tune of $1,000. And that doesn't include taxes on that sum, which, remember, will be considered a withdrawal if you don't repay it on schedule.
You should also know that while you might get a handful of years to repay a new 401(k) loan, if you leave your job, whether voluntarily or otherwise, that window could shrink to just a few months. So while you might think you have plenty of time to repay a 401(k) loan and avoid having it treated as an early withdrawal, that may not be the case in reality.
Your nest egg could really suffer
Penalties aside, another reason a 401(k) loan could backfire on you is that if it becomes a withdrawal, you'll risk retiring with a shortfall. Taking $10,000 out of your 401(k) as an unpaid loan may not seem like the biggest deal at first. But remember, the money in your 401(k) can grow a lot with the right investments.
So let's say your 401(k) normally generates an average annual 8% return, which is a bit below the stock market's average. If you end up having a $10,000 loan converted to a withdrawal you never pay back, you'll lose out on growth on that $10,000. And if you're 25 years away from retirement, that lost growth could cost you over $68,000.
That's why it's a good idea to look outside of your 401(k) when you need to borrow money. You might think your most convenient option is to borrow against funds that are already yours. But when a 401(k) loan goes haywire, the consequences can be pretty dire.
