Pay Debt with 401(k) Loan?

Mar 26, 2012 by

I’ve written here before about withdrawing money from an IRA to pay down high-interest debt. But what about taking money from a 401(k) or similar workplace retirement plan that allows employees to borrow from their accounts?

Loaning yourself money from your 401(k) to pay off debt feels attractive because—unlike a straight withdrawal from the account before age 59-1/2—no tax is due on the loan proceeds, and you’d be paying interest on the loan to yourself. Sounds pretty good. So what’s the catch?

Watch Out

There’s no catch really, but before borrowing from a workplace retirement account, be sure you know all the details:

  • 401(k) plan borrowers typically are required to repay the loan by automatic paycheck deduction over 5 years (longer if the loan is for a house purchase). How would this reduction in take-home pay affect your ability to keep up with bills? Suspending or reducing retirement plan loan payments if you get behind on bills is not allowed, so the borrower must be able to live on the new, lower take-home pay.
  • If the borrower leaves his or her job, by choice or not, the balance of any retirement plan loan likely would be due right away. If the borrower doesn’t have the cash to repay the loan balance, the IRS would then consider any unpaid balance an early withdrawal. Tax on the unpaid balance plus maybe a 10-percentage point penalty (depending on how the borrower spent the loan proceeds) would be due the following April 15th.
  • Borrowing money from a retirement account means the account won’t grow as large as it would have if left alone. To estimate the effect, try this calculator.

Think Through Other Options

Borrowing from a retirement account may, in certain situations, make sense, but other options are better in the large majority of cases. A free credit counseling session can help to identify and sort through your options for paying off high-interest debt.

What About Future 401(k) Contributions?

If necessary to help a well thought out debt pay off plan succeed, and after living expenses have been scrutinized and income bumped as much as possible, cutting temporarily contributions to a retirement plan might be a good idea. If your employer makes a matching contribution, try to continue contributing at least enough to get the full match. Restoring some or all of the retirement account contribution should be at the top of your list when the household budget loosens a bit.

Have you taken out a loan from a workplace retirement account? Did everything work out okay? Would you do it again under the same circumstances?

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