Despite a steadily rising inflation rate, many retirement plan participants have kept their hands off their 401(k) funds in recent years. But new data from Vanguard shows that savers may be having a change of heart.
Experts at Vanguard observed a slight uptick in new loans, nonhardship withdrawals, and hardship withdrawals—with hardship withdrawals reaching an all-time high according to data from October of this year. The research showed that 0.5% of account holders were making hardship withdrawals in October, compared to just 0.3% during the same time last year.
“The recent increase in households drawing on their employer-sponsored retirement accounts, could be a sign of some deterioration in the financial health of the U.S. consumer,” said Fiona Greig, global head of investor research and policy, in a statement.
Understanding your 401(k) funds
When you dip into your 401(k) early, that money will fall into one of three categories:
- Hardship withdrawal: A withdrawal from a participant’s account made to cover the cost of an immediate and heavy financial need, and limited to the amount necessary to satisfy that financial need. This withdrawal is taxed to the participant and will not be paid back to the borrower’s account.
- Nonhardship withdrawal: Also called early withdrawals, this is when you borrow from your 401(k) after age 59 ½ (or if you’ve met your specific plan’s requirements) without providing proof of a financial hardship.
- 401(k) loan: A 401(k) loan must be paid back to the borrower’s retirement account under the plan. Unlike 401(k) withdrawals, you don't have to pay taxes and penalties when you take a 401(k) loan.
Depending on the kind of loan or withdrawal, you could face steep penalties and taxes down the line. What’s more—borrowing more than you can afford to repay could delay your retirement or reduce your quality of life in your later years by forcing you to live on less than you’re used to.
“While it may look like a low-cost way to borrow, borrowing from your 401(k) is borrowing from your future,” says Jay Zigmont, certified financial planner and founder of Childfree Wealth. “You are taking money out of the market where it can grow. Additionally, if you lose your job, the 401(k) loan will become due, or else it will be seen as a disbursement, including taxes and a penalty.”
Alternatives to borrowing from your 401(k)
Most experts agree that borrowing from your future self should be a last resort. If you find yourself in a bind, consider these alternatives:
- Tap into your emergency fund. If you have an emergency fund built, tapping into those savings may be a better long-term strategy than taking on more debt and paying steep interest charges over time. As long as you make a plan for how you’ll replace the money so that your emergency fund can cover any unexpected expenses down the line.
- See if you can use your home equity to your advantage. A home-equity loan allows you to borrow against the market value of your house and receive a lump-sum payment in return. These loans charge higher interest rates than traditional mortgage loans, but lower rates than other types of debt like credit cards. The catch: a home equity loan puts your home at risk if you fail to repay your loan, so this option should be explored cautiously.
- Consider a 0% APR credit card. Don’t let high APRs steer you away from getting a new credit card. Some credit cards offer interest-free introductory periods. Depending on how much you need to borrow, you could benefit from this kind of offer and repay the amount you owe before interest on your balance accrues.
If you are going to borrow from your 401(k), it’s crucial that you have a clear goal for that money and a clear plan for how you’ll replenish those funds and cover the cost of any penalties or taxes imposed on the amount borrowed.
The takeaway
Tough times can sometimes force you to make major financial decisions on a whim. But borrowing from your nest egg can have significant long-term consequences. If your wallet is feeling the pain of inflation, consider all of your borrowing options before you tap into your 401(k).
