Every generation has their own challenges when it comes to saving for retirement. For Gen X, the disappearance of pension plans has left them to fund more of their retirement costs on their own than previous generations. Many have also found themselves sandwiched between adult children who still need support and elderly parents who need help with basic tasks.
Like everyone, Gen Xers also have to balance their future financial needs against their current ones, and this isn't always easy. Everyone handles this in their own way, but Gen X is more likely than other generations to use a strategy that makes saving enough for retirement a much harder task.
Image source: Getty Images.
Retirement savings are meant for retirement
Ideally, when you put money into a retirement account, you'll leave it there until you need it to cover your retirement costs. But this isn't a requirement. Most retirement accounts enable you to withdraw your funds, though there's often a 10% early withdrawal penalty for doing so. You may also have to pay income taxes on your withdrawal if it comes from a tax-deferred account.
The drawbacks to this are pretty obvious. You lose a substantial portion of your savings, and you'll face a higher tax bill in the present too. So it's usually a last resort for workers in need of some extra cash.
Some -- including about one in every four Gen X workers, according to Fidelity -- opt for 401(k) loans instead. You're borrowing money from your 401(k) rather than taking a distribution. As long as you pay the loan back with interest over time, you won't face income taxes or the early withdrawal penalty. You're also paying the interest back to yourself rather than to some other lender.
But 401(k) loans have their drawbacks too. First, you're limited to either $50,000 or half your vested balance -- whichever is smaller -- so you can't just take out as much as you want. Second, if you leave your job, the balance of the loan may come due, forcing you to either pay back a significant lump sum or pay taxes on the outstanding amount.
The biggest drawback, though, is the same issue with taking an early withdrawal from your retirement account. Your money isn't invested anymore, so it cannot grow for your future. And what you pay back in interest on your loan will likely be less than what you would've earned had you left the money untouched.
As a result, you'll have to save more money going forward to reach your savings goal. If this isn't feasible, you might have to delay retirement longer than you intended. This isn't to say it's always the wrong choice, but it's definitely worth exploring other options before taking out a 401(k) loan.
Alternatives to a 401(k) loan
First, it's always worth checking to see if you can cover your expenses without tapping your retirement funds. You can use an emergency fund for unplanned expenses if you have one. You might also be able to take out a traditional loan for certain properties, like a car. However, your credit score will affect whether you're approved and what kind of loan terms you get.
If you don't need to make an immediate purchase, consider saving up for it over time. Set up automatic transfers to a savings account, if possible, so you don't have to remember to make these contributions on your own.
When you have to tap your retirement savings, first check to see if a 401(k) loan is even an option. Not all plans allow them. If it is allowed for you, weigh its pros and cons against other types of retirement withdrawals.
Some retirement plans offer exceptions to the early withdrawal penalty for things like large medical expenses or a first home purchase. In addition, Roth IRAs allow for tax-free withdrawals of contributions at every age. This doesn't apply to earnings, though. Similarly, you can make tax-free medical withdrawals from health savings accounts (HSAs) at any age if you're trying to pay for a hospital bill.
You might still decide a 401(k) loan is your best option. If so, talk with your plan administrator to make sure you understand the terms of the loan, when you'll be expected to make payments, and what happens if you and the employer part ways. Make sure you're comfortable with these details before you take out the loan.
