401(k) loans vs. emergency savings: Making an informed choice

Financial planning is no easy feat, especially when you take financial emergencies into account. Whether it’s an unforeseen medical expense, urgent home repairs, or an unexpected job loss, these financial crises can appear without warning, threatening your carefully developed financial plans. 

It’s during these turbulent times that your financial decision-making can have long-lasting impacts on your financial wellbeing. Two strategies that are often considered for safeguarding against such emergencies are 401(k) loans and emergency savings funds. Each comes with its advantages and disadvantages, and the right choice will come down to your specific circumstances.

Understanding 401(k) loans

A 401(k) loan is a feature of many 401(k) retirement plans that allows you to borrow from your own savings and repay the amount with interest over an established period of time. This basically means that you’re borrowing from your future self. Compared to traditional loans, there’s no need for a credit check since you're using your own funds as collateral. There are a number of advantages to taking 401(k) loans, including:

• Speed of access - One of the most appealing aspects of a 401(k) loan is that you can tap into these funds quickly without the hassle of credit approval. 
• Lower interest rates - Interest rates on these loans are often lower than those for personal loans or credit cards, making it a cost-effective option.
• No credit reporting - 401(k) loans don't show up on your credit report, helping keep your debt-to-income ratio more favorable for future borrowing needs.

Given these advantages, taking out a 401(k) loan may sound like a win-win — but it’s not that simple. There are also several significant downsides to consider:

• Diminished retirement funds - With fewer retirement funds saved, this could potentially affect your future financial security. 
• Penalties for failure to repay - If you fail to repay the loan on schedule, you could face hefty taxes and penalties. 
• Job loss implications - If you leave a job or are let go from your employment, you might have to repay the loan in full by the next tax filing deadline in order to avoid it being counted as a taxable distribution. This could add financial strain during an already stressful time.

When you look at the data around Americans’ use of 401(k) loans, the drawbacks are further crystallized. Many employees that take out a 401(k) loan don’t receive the funds in time since they have to wait an average of 10 days for the disbursement. With 37% of 401(k) plan participants taking out a loan during a five-year period (National Bureau of Economic Research), many of them end up delaying their retirement as they work to pay back the funds. This leaves both employees and employers at a disadvantage.

Building and using an emergency savings fund

An emergency savings fund, or emergency savings account (ESA), is a critical financial safety net intended to cover unexpected expenses or financial emergencies without impacting your financial security. It’s a buffer that can keep you afloat and help you avoid going into debt. Compared to a 401(k), an emergency fund is designed to be used in the case of a financial crisis. It offers several benefits:

• Unmatched flexibility - When a crisis hits, you can access the money immediately and use it however you need to. 
• No penalties or interest - The money you withdraw isn’t subject to penalties nor does it incur interest. 
• Peace of mind - Having these funds available for the express purpose of financial emergencies helps minimize stress, often reducing the emotional toll of financial crises.

While the promise of emergency funds is great, actually building an ample emergency fund can be daunting. Like any other financial endeavor, contributing to an ESA requires discipline and a clear strategy, like setting aside a certain amount from each paycheck and having an established process for when you’ll use your emergency fund. Small steps, like automating your savings and making additional contributions when you come into additional cash (from inheritance, gifts, etc.), can help build your fund over time without feeling too overwhelming.

Making the right choice: 401(k) loans vs. emergency savings

When deciding between dipping into your 401(k) or emergency savings, consider factors like your job security, current debt, and long-term retirement strategy. The urgency and nature of the financial need should also weigh heavily in your decision-making process.

Imagine you’re faced with a large medical bill. If you have a stable job and a well-funded 401(k) but no emergency savings, a 401(k) loan might make sense. However, if you’re considering leaving your job soon or the market is down, exploring alternative options to a 401(k) loan may be advisable. 

In an ideal world, the best option for your financial planning is to work towards establishing both a 401(k) and a robust emergency savings fund. This option may not be feasible for you in the short-term, but it’s a smart goal to work toward in the long term. When you have both asset types established, they work together in synergy to better support your financial well-being.

The decision is yours

While 401(k) loans can be a convenient source of funds, they come with risks to your retirement savings that could impact your age of retirement or tax burden. Emergency funds, on the other hand, offer greater flexibility and less financial risk. Balancing your immediate needs with long-term financial health is key to making a wise decision. Work to factor both strategies into your financial planning for healthier financial wellness in the long run.