What Happens When You Borrow from Your Retirement Too Soon

Understanding financial wellness means feeling secure about your current financial situation and having confidence in your future financial stability. For many people, balancing day-to-day expenses while trying to meet long-term financial goals is a challenge that lasts throughout their careers.

Managing finances can sometimes feel like juggling too many balls at once. You're trying to pay the bills, save for future goals, and maybe even handle unexpected costs. Unfortunately, financial stress doesn't just affect your present—it can also put your future retirement at risk.

Why Financial Wellness Matters

Financial wellness is more than just having a budget. It's about feeling comfortable and confident with how you manage your money and plan for the future. But for many, the stress of managing everyday expenses and saving for future goals can be overwhelming and may affect long-term financial health.

Recent studies show that the lack of emergency savings is a significant issue. If you don't have a financial cushion to cover unexpected costs, you might end up dipping into your retirement savings, which can harm your long-term financial security. Keeping an emergency fund that covers at least three to six months of expenses can make a big difference in how much you're able to save for retirement and how well you'll be prepared for the future.

Common Financial Challenges

One major challenge is that many people aren't saving the recommended amount for retirement. Experts suggest saving about 15% of your income, including any employer contributions. Yet, a recent survey found that 55% of people either aren't saving enough for retirement or aren't sure if they are. Among these respondents, 62% said they were saving as much as they could afford.

We took a closer look at how borrowing from retirement accounts—often to cover emergency expenses—can impact your retirement savings. It's clear that addressing these financial wellness issues is crucial for helping individuals save effectively for retirement.

The Impact of Emergency Savings

Unexpected expenses are a part of life. Whether it's a sudden illness, an urgent home repair, or a car breakdown, these events can be costly. A recent survey revealed that 57% of Americans wouldn't be able to cover a $1,000 emergency expense without resorting to credit cards. In fact, 50% of survey respondents reported using credit cards to handle unexpected costs.

When you don't have an emergency fund, it can be tempting to borrow from your retirement savings. Our survey found that 14% of people might use their workplace retirement accounts for emergency expenses. This kind of borrowing can have long-term negative effects on your retirement savings, reducing the amount you'll have when you finally stop working.

The Cycle of Borrowing from Retirement Accounts

Using retirement savings for unexpected expenses can become a habit. Unless you address the root cause—often a lack of emergency savings—this pattern is likely to continue. Our research shows that borrowing from retirement accounts tends to increase with age, and it's not just an issue for younger workers.

Our data also indicates that people who frequently borrow from their retirement accounts have lower savings rates—about 2.3 percentage points less—compared to those who rarely or never borrow. This suggests that frequent borrowing can lead to reduced savings over time.

The Effect of Loans on Retirement Contributions

Interestingly, if you handle retirement loans strategically, you can lessen their long-term impact. We found that employees who took out one large loan (over $10,000) had contribution rates similar to those who didn't borrow at all.

However, taking multiple small loans has a more pronounced effect. Employees who took out several small loans (less than $2,000) per year had much lower average contribution rates. This means that having an emergency fund of just $1,000 to $2,000 could help you avoid the need for these small loans, keeping your retirement savings on track.

The Link Between Loan Frequency and Savings

Participants who took out multiple retirement loans each year had contribution rates that were, on average, 2.3 percentage points lower. We reviewed data from over 2 million plan participants from 2018 to 2022, which showed a clear connection between frequent borrowing and lower savings rates.

In addition, employees who borrowed from their retirement accounts had smaller average plan balances. Even though their ages and job tenures were similar, those who took more than two loans per year had account balances 60% smaller than those who didn't take any loans. This illustrates how frequent borrowing can significantly impact your retirement savings.

Building an Emergency Fund

Creating an emergency fund is one of the best ways to protect your financial future. This fund acts as a financial buffer, helping you manage unexpected expenses without having to rely on credit cards or borrow from your retirement accounts.

Start by setting aside $1,000 for emergencies. Once you have that, aim to build your fund up to cover three to six months of expenses if you have a stable, two-income household. If you're single or have a more unpredictable income—like freelance or commission-based work—aim for six months or more. If you ever need to use this fund, make sure to rebuild it as soon as possible.

The Benefits of an Emergency Fund

An emergency fund can keep your finances on track during tough times, such as losing your job or facing a temporary income drop. It can also cover large, unexpected expenses that you didn't plan for, helping you avoid the need to borrow from your retirement savings.

By maintaining an emergency fund, you can protect your retirement savings and alleviate some of the stress that comes with managing financial challenges. This not only helps you stay on track with your savings goals but also provides peace of mind knowing you’re prepared for life's surprises.

Conclusion

Managing everyday expenses and debt often leads to significant financial stress and can make it harder to save for retirement. Establishing and maintaining an emergency fund can help you handle unexpected costs and reduce the need to borrow from your retirement accounts. This approach can protect your long-term savings and give you greater peace of mind. Taking control of your financial wellness today will help ensure a more secure and comfortable retirement tomorrow.