Is Borrowing From 401k to Pay Off Debt a Good Idea?

borrowing from 401k to pay off debt

If you have credit card debt, but you have some retirement savings, there’s a good chance that you’ve thought about borrowing from a 401(k) to pay off debt. While borrowing from your retirement account is certainly an option, like any other financial decision, it does come with its own pros and cons. With that in mind, we’ve taken the liberty of exploring this option in-depth for you below. Keep reading to learn more.

Is borrowing from a 401(k) to pay off debt possible?

First and foremost, yes, it is possible to borrow from a 401(k) to pay off debt. The question is whether or not it is advisable to do so. Typically, your retirement savings should stay in your account until you are old enough to start taking regular distributions. Spending the money before you’ve reached retirement age may leave you short in your golden years.

In light of that, if you are considering borrowing money from a retirement account to pay off debt, it’s a good idea to talk to an advisor about your financial goals first. They may recommend temporarily pausing retirement contributions and using the extra income to pay down your debts rather than taking money out of your account. However, the decision is yours to make.

Two ways to consider using a 401(k) to pay off debt

If you have decided to borrow from your 401k to pay off debt, there are two ways to do so. One option is to take a 401(k) withdrawal, and on the other hand, you can consider using a 401(k) loan. Each of these methods comes with its own considerations. We’ve laid them out for you below.

Taking a 401(k) withdrawal

Taking a 401(k) withdrawal involves taking money out of your retirement account without the intent to put it back. While this method might seem like an easy way to become debt-free, it does come with some tax considerations.

According to current IRS guidelines, if you’re under the age of 59 ½, you’re obligated to pay a 10% early withdrawal penalty on any money you take out of your 401(k). Unfortunately, that penalty is on top of getting taxed on the amount that you withdraw, which will be treated as regular income.

Using a 401(K) loan

Fortunately, there is a way to avoid paying that penalty. You can take out a 401(k) loan. While not every 401(k) plan allows for this option, those that do allow you to borrow money from your retirement account and pay it back over time with interest.

In this case, there are certain rules that you need to follow when repairing the loan. Otherwise, the money will get taxed as a distribution. While you’ll want to contact your plan administrator or read the IRS website for more specifics, in general, you should expect to repay the loan within five years, and you’ll need to make quarterly payments on the amount that you borrowed. Each of the payments should also be equal in size.

The pros and cons of 401(k) loan for debt consolidation

Given the tax implications of taking an early withdrawal from your retirement account, most people choose to use a 401(k) loan for debt consolidation instead. With that in mind, there are some pros and cons of using a 401(k) loan for debt consolidation. Read on to learn if this debt payoff method will work for you,

Pros

  • You’ll be able to pay off your debts: With this method, you can borrow the money you need to pay off your credit cards and consolidate your debt into one payment.
  • You can have a more flexible repayment schedule: The repayment schedule on a 401(k) loan is more flexible than typical installment loans. As long as you can repay the amount you’ve borrowed within five years, you’re only required to make quarterly payments.
  • You get to keep the interest: While 401(k) loans do come with interest charges, you get to keep any interest that you’ve paid instead of it going to your lender.

Cons

  • If you don’t repay the loan in time, it will count as a withdrawal: You’ll be taxed on that income. You’ll also have to pay a 10% early withdrawal penalty.
  • You may not be able to make retirement contributions: Some retirement plans do not allow you to make contributions to your retirement account while you’ve borrowed funds in the form of a 401(k) loan.
  • Not all 401(k) plans allow for loans: To take out a 401(k) loan, your plan must specifically state that loans are permitted. If you’re not sure what your plan allows, your best bet is to check with your plan administrator.

The bottom line on borrowing against a 401(k) to pay off credit cards

Taking out a 401(k) loan can be a flexible and affordable option for paying off credit card debt. Still, if you’re going to go this route, it’s best to proceed with caution. At a minimum, you’re going to want to take some time to reflect on your financial attitude and spending habits. Once you borrow against your retirement account to pay off debt, it’s a good idea to examine your budget and spending habits regularly. Doing so can help you avoid ending up with debts that feel overwhelming.

If you have more questions about ways that you can consolidate your debts, call us at (866) 890-7337 or fill out our short contact form. We’ll be in touch with more information about how we can help you.

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