Borrowing Money From 401k To Pay Off Debt: The Pros and Cons

Debt is drowning America. A decade after the Great Recession many Americans are still suffering its effects on the U.S. economy. Many people haven’t recovered yet from the consequences of losing their jobs, most of them are still stuck in debt and can’t seem to get out.

Contrary to what economists claimed that the economy is in the process of recovering, many Americans are still unable to support their families and pay their debts. To solve financial difficulties some people are entertaining the thought of borrowing money from 401k to pay off debt.

According to research, the average amount of personal debt in America is $38,000 with credit cards taking 25% chunk of the total. With 2 out of 10 Americans paying at least half of their monthly income to creditors, it is easy to see that almost a quarter of the entire population are into debt.

Debt is not new in America and is not bad either. People are able to purchase cars, homes, and other necessities they can use in the present and pay for by installment for months or even years. They can also send their children to college with the help of credit cards and student loans. While paying for the monthly minimum amount may be doable pre-Recession, it’s now harder to do with the high rate of unemployment and underemployment impacting the people of America. The introduction of credit cards in the late 1950s had given U.S. consumers the higher buying power but it also contributed to the financial tragedy distressing Americans nowadays.

Being in debt can curtail people’s freedom to use their money on things that they want or need. It also puts them at the mercy of creditors and debt collectors that can sue them if they won’t pay up. Fortunately, Americans have legal protections they can use for paying back creditors as well as protect themselves from unlawful debt collection practices. Some states even have their own laws covering their residents which includes security for credit cardholders. Florida, New York, Texas, and California are just some of these U.S. states.

Tapping 401(k) to Pay Off Debt

When a person founds himself in trouble with your finances, you turn to your savings account and properties to get the money to pay off lenders. If these are not enough or not available, borrowing money from 401k to pay off debt is the next solution he might think of. While those who are facing a debt so huge that it will take them decades to repay would as well be cashing out 401k to pay off debt just to eliminate their debt as fast as they can.

But, can one take money from their 401(k)? The answer is no. The money is yours, granted, but it is supposed to be allotted for retirement. If it will be taken out before then, IRS will charge that person for income taxes and a penalty of 10 percent. Another thing is the missed opportunity to earn an annual return if money will be pulled out of the market to pay off creditors. This means that withdrawing 401(k) for debt repayment is a last resort when other methods will not work. Taking out 401k is an extreme step for someone into debt would do. One can, however, get a 401(k) loan for debt repayment.

The Pros and Cons of 401(k) Loan

Many employers are now offering 401(k) plan as part of their employee’s benefits package. The money being saved is intended for retirement. Yet, some plans offer low-interest loan option for contributors who want to pay off credit cards with high interests. This, however, should be approached with more caution.

Depending on the employer policies, 401(k) plan providers allow employees to take out a loan up to half of their account balance with a maximum limit of $50, 000. Repayment of the loan may take as long as 5 years.

If one looks at it, a 401(k) loan seems an ideal solution to removing debt fast and permanently. A contributor borrows their own money and pays interest to themself. Yet, this method comes with some disadvantages which may outweigh the benefits if not analyzed thoroughly. These are the pros and cons that an individual should consider when borrowing money from 401k to pay off debt.

The Pros

  • One pay interest to their own account
  • It’s cheaper than credit card interests
  • No effect on the credit score

The Cons

  • It can significantly unsettle one’s retirement savings
  • 401(k) loan comes with risks such as penalties and tax consequences
  • The loan will not resolve the causes of the debt accumulation
  • A 401(k) loan is not easy to discharge in bankruptcy than credit card debt
  • Any money borrowed from a 401(k) plan fails to catch the benefits of both compound interest and market gains
  • Some plans will not allow making contributions to the retirement fund while one has an outstanding loan
  • When the contributor leaves their job, he/she will be required to repay the loan within a period of 60 days. If he can’t comply, the outstanding amount will be recorded as an early withdrawal and he will be directed to pay income tax and the 10 percent penalty.

Taking a loan from retirement savings is an acceptable choice when all other options have been exhausted. But, it should be done with a regulated financial plan so the borrower will not find himself in a deeper financial pit than the one produced by your credit cards. Furthermore, as the cons are higher than the pros, borrowing money from 401k to pay off debt should be placed at the bottom of one’s list of options.

Alternatives to a 401(k) Loan

Borrowing or cashing out 401k to pay off debt is only a last option. There are other ways to climb out of debt without cracking one’s retirement savings. Here are other methods for consideration.

  1. Create a debt consolidation plan to pay all credit card debt within 5 years.
  2. Consult a credit counselor or attorney about debt relief options like bankruptcy or debt management.
  3. Check into a balance transfer credit card that offers 0% interest for as long as two years.
  4. Get a personal loan with interest rates lower than regular credit card rates.
  5. Take a part-time job or a side hustle to gain extra cash for debt repayment.
  6. Sell everything that can be given up like clothes, books, appliances, etc.
  7. Live on a budget to free up more money for paying the debt.

When all of these strategies have been employed and the debt is still not resolved then a 401(k) will be the next option.

Points to Keep in Mind in a 401(k) Loan

To minimize the retirement risk that borrowing from retirement savings brings, these points should be kept in mind:

  • Take the option of borrowing money from 401k to pay off debt only when the reason for incurring debt is realized and measures are taken to avoid being in the same situation again.
  • Borrow only the amount that one can repay on schedule in a short period of time.
  • If the plan allows it, continue contributions while repaying the loan to gain any company match that the employer offers.
  • Stop credit card use while repaying outstanding debt.

Takeaway

The perception that a 401(k) is accessible money that one can withdraw when you are having trouble with your finances poses a risk to one’s retirement in the future. Once a person starts cashing out 401k to pay off debt, there’s a probability that he will take another withdrawal when he gets into debt again. This happens when the root of the debt problem is not recognized and necessary steps are not taken so as not to get into the same financial trouble in the future.

If borrowing money from 401k to pay off debt is the only remaining choice, ensure that all the terms are clearly understood. Having a plan on how the loan will be repaid is important so as not to risk losing more benefits that a 401(k) plan could bring. By making extra payments, one can pay off the loan faster and go back to earning returns on their investment. You can also worry less about not fulfilling your loan obligation or getting a huge tax bill if you decided to leave your job.

Reference:

https://news.northwesternmutual.com/planning-and-progress-2018