401(k) Loan to Pay Off Debt: Is It a Good Idea?
If you are in a position where your debt is becoming unmanageable and the idea of wiping it out completely in one fell swoop — or at least making a significant dent in it — is appealing, you may be tossing around the idea of borrowing from your 401(k).
After all, it is your money. Wouldn’t using it to pay off your debt be a wise move? Well, maybe. But also, maybe not.
Using a 401(k) loan to pay off debt has both immediate and long-term implications that should be explored and understood fully before moving forward. And in many cases, there may be a better solution to getting rid of your debt.
In this article, we’ll take a look at everything you should consider before borrowing from your 401(k) to eliminate debt, the associated benefits and risks, as well as some alternative solutions.
Table of Contents
What is a 401(k) loan?
Most 401(k) plans, and also 403(b) and 457(b) plans, allow you to borrow against the available funds in the plan. The money must be paid back, with interest, within a specific amount of time, very much like financing a car or taking out student loans.
A loan from your 401(k) is different from a withdrawal or distribution, which are not repaid. Because you are borrowing the money with a promise to restore the balance, the money is not taxed. However, there are tax implications if the terms of the loan are not met, which we will cover later.
Funds can be borrowed for any reason. A hardship or a need for the money does not need to be demonstrated as is the case with a hardship distribution.
401(k) plans differ from other retirement plans such as IRAs, Roth IRAs, SEPs, and other IRA-based plans in that those plans do not allow loans. Any money is withdrawn from an IRA-based plan before age 59 ½ is considered an early withdrawal and is subject to a 10% tax penalty unless you qualify for an exception.
Your 401(k) plan documents will state whether or not loans are permitted, and the specific terms surrounding borrowing from your plan.
Here is a look at some frequently asked questions regarding 401(k) loans.
How much can I borrow?
There are limitations on how much you can borrow from your 401(k). Most plans cap loans at either 50% of the vested balance (the amount you fully own) or $50,000, whichever is less. If 50% of your vested account balance is less than $10,000, most plans will allow a loan up to $10,000, provided the amount borrowed does not exceed the total balance.
If your plan permits more than one loan at a time, and you have any outstanding 401(k) loans, the total amount borrowed across all loans must not exceed the maximum amount allowed.
What are the interest rates?
The interest rate paid back on 401(k) loans is typically the current prime rate plus 1%. The specific interest rate for your plan will be outlined in your plan documents.
How long does it take to get the money?
Securing a loan is usually a quick process. The procedure involves completing paperwork with your HR or benefits department or plan provider. In most cases, once the request is approved, you will receive the money within a few days.
How long till I have to pay the money back?
401(k) loans must be repaid within five years, although you can also choose to pay at a more accelerated rate. An exception to the five-year term is if the purpose of the loan is for a primary residence, in which case a more extended repayment schedule can be arranged.
Payments are made in equal installments, at least quarterly, and include the loan amount plus interest. Loan payments are not considered plan contributions.
What happens if I default on a payment?
If a payment is missed, or if the loan is not paid within the five-year period, the unpaid balance is considered a taxable distribution at your current tax rate.
Again, check your plan documents for details regarding loans including the interest rate, repayment terms and any other specifics that are unique to your plan.
What happens if I lose or leave my job?
In the past, the main risk with 401(k) loan was that the loan would become due immediately if you were terminated or left your job. If it wasn’t paid off immediately, the loan would be considered a taxable plan distribution and you could get hit with early withdrawal penalties. With the new tax law, however, these rules have softened a bit. The new law allows ex-employees to roll over their loan into a new or existing Individual Retirement Account (IRA), 401(k) plan or another qualified retirement account, which is separate from your former employer’s plan. From there, you pay off the loan in the new account, according to the IRS.
Should I withdraw money from my 401(k) to pay a debt?
Now that we’ve reviewed the terms and conditions of borrowing from your 401K, the question still stands: Is it a good idea to use a 401(k) loan to pay off debt?
Generally speaking, unplugging retirement funds to pay off debt is not recommended. Richard A. Lamore, senior partner and investment executive at Boundless Financial Solutions, LLC in Newington, Conn., typically advises clients against using retirement funds to pay off debt but says there are some scenarios where a loan can be advantageous.
“I don’t recommend it on the whole,” Lamore said. “But is it a valuable tool in the right circumstances to help someone solve a situation? Absolutely.”
Let’s take a look at the benefits and risks associated with borrowing from your 401(k) and some instances where it might make sense.
The benefits of using a 401(k) loan when paying a debt
- No credit check. Unlike borrowing from a bank or other institution, your credit score and credit history are not factors when requesting a 401(k) loan. Conversely, the loan does not impact your credit.
- Lower interest rates. The interest rate on the loan is likely lower than the interest rates on your credit cards and other debts, and it is potentially lower than a comparable loan you would get in the market.
- Paying interest to yourself. While paying yourself interest can be touted as a benefit, it is also a negative. The benefit of earning interest, in general, is that it comes from an outside source. Paying it to yourself is counterproductive.
- Quick access to cash. Once your request for the loan is approved, you should receive the funds within days.
- No prepayment penalties. You can choose to repay the loan before the five-year period without penalty.
- No taxes or early withdrawal penalties. The loan is not taxed and is not subject to penalties provided you stay within the terms of the loan.
The risks of using a 401(k) loan for paying a debt
- Sacrificing retirement. The most significant drawback is that you are unplugging funds that were intended for your retirement. You lose the benefit of earning compound interest and forfeit the advantages of saving the funds in a 401(k) in the first place. A $20,000 loan will cost you $11,540 if repaid on time, based on an 8% rate of return on the 401(k) funds and a 5.75% interest rate on the loan. Should the loan go unpaid, however, you stand to lose $399,204 in earnings, additional taxes, and penalties, based on being 35 years away from retirement.
- Double taxation on the interest. When you repay the loan, payments are made with after-tax dollars. When distributions are made later down the road, the interest that you paid yourself will be taxed again.
- Repayment plan. There is not much flexibility in terms of repaying the loan except to pay it faster. If you miss a payment, then you risk being in default.
- Chances of repeat loans If you are using the loan to pay off debt, without preventing further debt, then you are likely to dip in the 401(k) in the future.
- Halting contributions. You not only unplug invested funds from earning interest but unless you are contributing to your 401(k) above what you are paying back on the loan, then you miss out on contributing during the repayment period.
- Risk of default. If you miss paying the loan according to the terms, the outstanding balance will be considered a distribution subject to income tax and an additional 10% penalty.
- Payback is accelerated if you lose your job or quit. Review your plan rules carefully.
- There may be loan origination fees associated with a 401(k) loan.
An overarching risk with using a 401(k) loan to pay off debt is that if it’s seen as a quick fix without addressing behaviors that led to the debt, then you will likely rack up any debt you pay off with the loan and will find yourself in the same position again.
Lamore has had clients who borrowed from their 401(k) plans against his counsel and said, “Taking a loan out from your 401(k) can be a solution to the problem, or it can be a Band-Aid. If it’s a Band-Aid, it’s going to end … horribly.”
When it does NOT make sense to borrow from your 401(k) to pay off debt
- As a quick fix. If you are looking to get rid of debt, but haven’t addressed the habits and behaviors that led to the debt.
- If you are close to retirement age.
- If you haven’t explored other avenues of paying off the debt.
- In most cases, (unless it’s a last resort).
When it makes sense to borrow from your 401(k) to pay off debt
In a case where someone is planning to withdraw funds anyway or receive a distribution, Lamore sees taking a 401(k) loan as a lesser evil. “From a strict numbers point of view, I wouldn’t advise [taking a 401(k) loan],” Lamore told LendingTree, “but it’s better than taking a 10% penalty and having to pay taxes.”
There are some additional scenarios where borrowing from your 401(k) may make sense.
- If you owe a significant amount to the IRS. A 401(k) loan can alleviate the pressure and expense of owing the IRS back taxes, provided you have exhausted all options in setting up a manageable payment plan.
- You are paying extremely high interest rates. If the rates on your credit cards and other debts are through the roof and you’re unable to negotiate or refinance, using your 401(k) can be a solution.
- To avoid defaulting on a private student loan. Private loans rarely offer flexible repayment options if you fall behind. If you have a federal student loan, however, you should have flexible repayment options. Call your loan servicer to review your options before you dip into your nest egg.
- To avoid bankruptcy or foreclosure.
Even in the above cases, unplugging retirement funds to pay off debt should be seen as a last resort. Other options should be explored, which we will cover in a bit.
Options to consider before a 401(k) loan
Before you go ahead and remove your funds from retirement, make sure you have a look at every option available. Here are some alternatives to consider.
Create your own debt payment plan.
If you are not currently budgeting, you may have the ability to pay more on your debt than you realize. Lamore suggests individuals start following a budget and apply any available funds to paying down debts.
Pausing 401(k) contributions.
While this is not ideal because you also miss out on the benefits of earning interest, pausing contributions to eliminate your debt is better than unplugging funds that are already invested, and there’s no risk of not being able to repay a loan.
Seek out debt management help.
If you are struggling with meeting your payments and could use some help, entering a debt management program could be a solution.
Debt consolidation with a personal loan or alternative option.
Again, if the debt is too overwhelming and you find yourself avoiding and falling behind, look into debt consolidation to see if it’s for you. There’s more than one way to consolidate debt. You can take out a personal loan or use a balance transfer credit card, for example.
Selling investments or assets.
If you have investments outside of what you have in your retirement accounts or assets of value, consider selling them.
Get a second job.
One way to increase your ability to pay down your debt without dipping into retirement funds is to take on a second job. There are ways to make money to help you pay down your debt.
Speak to a professional.
According to Lamore, individuals do not always fully understand the implications of borrowing from their 401(k) before moving forward. He suggests discussing your specific situation with an investment professional who can walk you through all your options.
How to get a 401(k) loan
If you decide to move forward, after pursuing alternatives, the process of requesting a loan is pretty quick and simple. Again, check your plan documents for the exact procedure, but typically, you would submit paperwork to your HR or benefits department or your plan servicer, detailing the amount you would like to borrow and confirming the details regarding the loan.
If you have made the decision to unplug retirement funds to pay off debt, make sure you use the funds as planned. Pay off the debt, and put systems in place to avoid incurring the debt again. Use any room you have in your budget to establish an emergency fund to avoid resorting to debt in an emergency.
Watch your payments to make sure you stay on schedule with repaying the loan on time. Your payroll statements should provide a summary of where you stand.
Proceed with caution
In summary, borrowing from your 401(k) to pay off is not generally advisable and should be seen as a last resort. The risks outweigh the benefits, and the consequences of defaulting are significant.
Explore all other options for paying off your debt before unplugging your retirement funds. And if you choose to move forward, make sure you understand all aspects of dipping into your 401(k).