When It Makes Sense to Borrow From Your 401(k)
You should do other things first, but sometimes a 401(k) loan is a valid way to pay down high-interest credit card debt
Tapping your retirement plan to pay off high-interest debt sounds tempting, especially with interest rates on the rise. Then there’s the added satisfaction of paying the interest on a 401(k) loan back to yourself, not the bank.
But there’s a whole host of reasons why you shouldn’t touch that money. Perhaps the biggest right now is that you’re taking money out of the stock market after a major sell-off.
“Chances are your account is down right now, so you’re locking in a loss,” says Lauren Lindsay, a certified financial planner (CFP) based in Houston.
That’s why financial professionals recommend you explore other options before raiding your 401(k).
Here are some of the benefits of 401(k) loans:
- You can usually take up to 50 percent of your 401(k) balance, up to $50,000, out of the plan and use it without incurring any taxes or penalties, as long as you pay the loan back in time.
- You pay the interest on the loan back to yourself instead of paying it to a bank, or to the 401(k) provider.
- You normally get up to five years to repay this type of loan, and repayments are made automatically with each payroll cycle.
- Applying for a loan isn’t going to impact your credit score.
- Origination fees and interest rates for these loans tend to be small. “Typically, you find plans have tied their rate to prime plus 1 or 2 percent—today that’s 4.75 percent plus 1 or 2 percent,” says Jarrod Sandra, a CFP based in Crowley, Texas.
- Plans tend to limit the number of loans that can be outstanding or taken in a year, reducing borrowers temptation to overuse the tool. “The rules vary depending on the plan, so before you do anything, it’s important to connect with your provider to confirm what applies to your specific product,” says Sandra.
Still, the downside of 401(k) loans is considerable.
“Taking a loan from your 401(k) can go terribly wrong,” says Jason Siperstein, a CFP based in Rhode Island.
Here are some of the dangers you need to be aware of:
- If you change jobs—or even worse, lose your job—you’ll have to pay the remaining balance immediately. “An outstanding 401(k) could make changing jobs very expensive!” says Herman Thompson, an Atlanta-based CFP. “This means you may only have a short window (usually 60 days) to completely repay the outstanding loan. Any amount you don’t repay becomes subject to income tax and (if you’re under 59.5 years old) a 10 percent penalty. Ouch!”
- A 401(k) loan can’t be discharged in bankruptcy. “If you can’t pay back the loan, it’s seen as a withdrawal,” says Steve Wilson, founder of Bankdash, a personal finance site dedicated to improving consumer understanding about banks.
- Your future investments and retirement plans may be hurt. “The money you borrow won’t be available to work for you if the market recovers,” says Justin Stevens, a Rochester-based CFP. “This could be more costly than the interest charges on the credit cards over five years,” he says.
- Borrowing now is like buying stocks high and selling them low, says Lindsay, the Houston-based CFP.
- You may get double taxed. “Yes, the loan comes out with no taxes, but the payments go in after taxes. Then when the money is taken out down the road, it will be taxed again,” says Kyle Newell a CFP based in Winter Garden, Fla.