The Coronavirus Aid, Relief, and Economic Security Act (or CARES Act for short) relaxed the rules for 401(k) loans issued in response to the COVID-19 pandemic. It is now possible to borrow up to $100,000 or 100% of your acquired account balance, starting from a maximum of $50,000 or 50%.
But despite the rule change, the search for loyalty shows that most Americans are not taking advantage of the ability to borrow. In fact, the percentage of people who initiated a 401(k) loan increased from 2.6% in the last quarter of 2019 to 2.3% in the first quarter of 2020.
That’s roughly the same number of retirement savers who took out a loan in the same quarter of 2019, long before the pandemic hit.
Leaving 401(k) funds invested is the smart choice
Although the CARES Act makes it easier to borrow from a 401(k), that doesn’t mean it’s a good idea.
While you’re paying yourself interest on a 401(k) loan, chances are the rate you’re paying will be lower than what you could have earned by leaving that money invested. You’ll miss out on years of potential gains during repayment. And some of those years may be the ones in which you might outperform the average during the inevitable coronavirus economic recovery.
You also run the risk of not paying the money back, which could be a big problem. Defaulting on your 401(k) loan would result in a 10% early withdrawal penalty, not to mention losing any gains the money might have made through retirement. If that’s 20 years from now and you borrow but don’t repay the full $100,000 allowed by the CARES Act, your nest egg would be up to $387,000 less than it would have been (assuming an annual return average of 7%). You could reduce your retirement income by more than $15,000 annually if you follow the 4% rule for retirement account withdrawals.
The downside often outweighs the upside, which is likely why Fidelity data shows Americans aren’t jumping at the chance to loot their retirement accounts to help them get through the great confinement.
What other options are available?
Rather than borrowing money from a 401(k) if you are having financial difficulty, explore other sources of help first. Extended unemployment benefits are available for many workers, for example. And the government has already authorized a stimulus check, with additional payments considered.
Reducing your budget to live on the funds you have outside of your 401(k) is also a better and easier option now, as social distancing has eliminated some of the most common forms of spending.
If you still need extra money after cutting your budget and taking advantage of other aid, consider using a Credit card 0% APR covering short-term expenses may be a better option than borrowing from your retirement account.
Depending on the card, you can charge purchases for a year or more without having to pay interest, so you’ll hopefully have time to get back on your feet and pay the charges before the interest kicks in. .
This can be risky because you’ll end up with expensive credit card debt if you can’t pay off the loan as scheduled, but you can always withdraw money from a retirement account later if needed. The CARES Act also states that you have until the end of the year to make a penalty-free withdrawal of up to $100,000, and a withdrawal could is better than a loan right now.