Using Your 401(k) to Pay Off Debt is Risky: Here’s Why

Understand what you’re getting into before putting your retirement security at risk.
6 minute read | 5/16/19May 16, 2019
using retirement savings to pay off debt

Many of us are dealing with debt. In fact, most Americans are in debt, according to a recent analysis by Nitro. Debt can weigh you down until paying it off as quickly as possible becomes almost an obsession. You might even begin to think that borrowing a 401(k) loan to pay off debt makes a lot of sense.

“For some people, the 401(k) plan is the largest pool of saving,” says Adam Bergman, a tax attorney and president of both the IRA Financial Group and IRA Financial Trust Company. “It [can sometimes] feel like the only real option for paying off debt.”

However, while there are some advantages to dipping into your retirement savings to pay off debt, there are some downsides. Before you decide to put your future at risk, it’s vital to know what you’re getting into.

What is a 401(k) loan?

A 401(k) loan is what it sounds like — you borrow money from your 401(k) for any purpose, and then you repay it.

“Using a 401(k) plan loan option allows you to use your retirement savings for any purpose, including paying off debt,” says Bergman. “You repay the money back into your 401(k), including paying interest to yourself.”

Not every plan offers a loan option, though. Additionally, among companies that do offer a plan, you might have restrictions. For example, you may not be able to keep contributing new money to your 401(k) until after you pay off the loan. Check with your human resources department to find out how to borrow from your 401(k) and what terms you might be stuck with.

Benefits Drawbacks
  • Interest rates are usually low
  • You repay interest to yourself, putting more back into the 401(k)
  • As long as you meet the terms of the loan, you won’t have penalties and taxes
  • You can use the money for any purpose
  • If you leave your job, you have to repay the balance quickly
  • Defaulted loan amounts are treated as distributions, with accompanying taxes and penalties
  • You might not be able to contribute to the 401(k) while you have a loan balance
  • You miss out on compounding returns while the money is out of your account

How much can be borrowed?

When borrowing from a 401(k) to pay off debt, says Christine Centeno, a CFP and the owner of Simplicity Wealth Management, you’re limited to the lesser of:

  • $50,000
  • 50% of your vested balance

The exception is if your balance is $10,000 or less. At that point, she says, you can borrow up to $10,000 from your 401(k).

How long do you have to pay it back?

For the most part, 401(k) loans come with a repayment term of five years, according to Bergman. He also points out that the interest rate on the loan has to be at least the prime rate, although it can be higher.

Advantages of borrowing from a 401(k) to pay off debt

The biggest advantage to using a 401(k) to pay off credit cards or other high-interest debt is the relatively low rate.

“The interest rate on a 401(k) loan is fixed and significantly lower than outstanding credit card interest rates,” says Centeno. “It can be a smart decision and save a significant amount of interest.”

Plus, because of the short time frame, you know you’ll be able to pay off the loan quickly, says Centeno, potentially faster than you would be able to otherwise. Additionally, depending on the policies associated with your plan, you might not have to worry about strict credit criteria. For some borrowers, it’s possible to get a lower rate than they would otherwise qualify for.

Just because there are advantages, though, doesn’t necessarily mean using a 401(k) loan is a good idea.

Why 401(k) loans are risky

You might not pay it off

One of the biggest concerns with borrowing from your 401(k) is the fact that you just might not pay off the loan. Bergman points to study from Deloitte, indicating that defaults might drain as much as $2 trillion from Americans’ 401(k) account balances over the next 10 years.

For a typical borrower, this could mean a loss of $300,000 in retirement security over the course of a career. That could be a big blow to a saver — especially if you can’t contribute to your 401(k) while you have an outstanding loan.

“When you don’t pay back your 401(k) loan, you’re subject to taxes and a 10% penalty if you’re under the age of 59 ½,” says Bergman. “That’s a big blow.”

You might inadvertently accelerate the repayment period

On top of the potential long-term problems resulting from default, Centeno points out that if you leave your job (or if you’re laid off), the balance of your loan is due by your tax filing date.

“If you left your job in October 2018, for example, the balance would be due by April 15, 2019,” says Centeno. “Miss that deadline, and the outstanding amount becomes a distribution and subject to taxes and penalties.”

You miss out on compounding interest

Finally, you miss out compounding returns. Even if you don’t default, you miss out on up to five years’ of potential gains. If you take your loans out during a market downtown, you lock in losses and miss out on the gains from a recovery. When you start contributing again, you might be buying at a higher price, reducing your ability to enjoy future gains. There is no making up for time in the market.

When it doesn’t make sense to use a 401(k) loan

While there are situations when it makes sense to use a 401(k) loan to help you pay down debt, it’s important to carefully consider your situation. Here are some times when borrowing from a 401(k) to pay off debt doesn’t make sense.

  • If you’re nearing retirement and can’t afford to take the money out of the market
  • When you see it as a quick fix and don’t have a plan to improve your long-term finances
  • If you’re unsure of your job security and think you might change jobs before you pay off the loan

Additionally, it might not make sense to use a 401(k) loan to pay off student loans. If you have a lower interest rate and you rely on federal protections like PSLF (Public Service Loan Forgiveness) or income-driven repayment, you could lose out by taking money out of your 401(k).

Less risky debt repayment options

In some cases, you might be better off using other types of loans to pay off your debt, especially if you have good credit.

Personal loans

Low-rate personal loans can help you pay off debt if you have a smaller amount of high-interest debt and can qualify for a reasonable rate. In many cases, you can borrow up to $35,000 or $40,000, depending on the lender. Some lenders, like SoFi, allow personal loans of up to $100,000. Many personal loans require repayment within three to five years as well, which allows you to limit how long you remain in debt.

When using a personal loan to consolidate, you don’t have to worry about the fact that you could be charged taxes and penalties if you switch jobs or if something goes wrong and you can’t make payments. While your credit might be impacted from default, your retirement account still remains intact. However, to get the best rates, you need to have good credit and you might need to meet other requirements.

Consolidation loans

With a debt consolidation loan, you can benefit from getting everything in one place, paying it off with a bigger loan. You can usually get up to $35,000 to $50,000 when consolidating debt, and you might have as long as five years to pay off a debt consolidation loan. Additionally, you can usually get reasonable interest rates, especially if your credit is good.

However, you might need to fill out more paperwork and go through a more stringent process when you use a debt consolidation loan. If you need more help getting out of debt, you can enter other types of debt relief and debt consolidation programs. These allow you to get help with managing your debt and getting rid of it without putting your future at risk.

With a personal loan or a debt consolidation loan, you can still contribute to your retirement account, and the assets in your 401(k) remain mostly safe from debt collectors.

Is a 401(k) loan right for you?

Carefully consider before you get a 401(k) loan. If you’re relatively young and can make up for the loss of time in the market later, borrowing this type of loan to pay off debt may help you get back on your financial feet — especially if you fulfill the terms and repay yourself with interest.

You do need to be aware of the risks, however, especially if you’re not sure you’re going to stick with your current job for very long.

“In some cases, they make a lot of sense, so they’re worth exploring as an alternative,” says Centeno. “But 401(k) loans can also be risky, so compare them carefully with other options.”

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