When you are ready to pay off debt, you have different options available. You can live below your means to accumulate some extra money, you can use your savings account, you can borrow against your life insurance, you can ask friends or family for help, you can take out a home equity loan or you can pull money out of your 401(k). Borrowing from your 401(k) may seem like a good idea because you are borrowing money from yourself. It can be, but there are drawbacks.
How it Works
Your 401(k) may be your money, but you have to follow certain rules to get it. In most cases, you can borrow up to half of your balance up to $50,000, but you have to pay back what you borrow, typically within five years. You need to make the payments back on a regular basis, at least quarterly. You can also take out a hardship withdrawal if you have an emergency, but you pay a 10 percent penalty if you do that.
What is tempting about borrowing from your 401(k) is that you don’t have to apply for the loan – you can count on getting it – and you won’t be subjected to a credit check. The interest you pay back on a loan from your 401(k) is usually less than the interest you pay on your credit cards, for example.
Even though it may be tempting to pull money from your 401(k) to pay off debt, you shouldn’t solve a problem by wiping out your retirement, advises consumer reporter Clark Howard writing for CNN Living. The money that you take out stops appreciating in the form of interest or dividends, which means you have less for retirement. You lose your tax-sheltered advantage, too. You repay your loan with after-tax dollars and then, when you retire, you pay taxes again. If you can’t pay back the loan, the loan is treated as an early withdrawal, which you owe federal and state taxes on plus the 10 percent penalty.
It’s risky to tap your 401(k) if your job is not secure or if it’s likely you’ll want to leave soon for a different job. As soon as you leave or are laid off, your loan becomes due immediately. If you can’t pay it back, it reverts to an early withdrawal, complete with the taxes and penalties. Only consider borrowing from your 401(k) if you are absolutely sure you will have that same job for the term of the loan.
In some cases, such as if you are going to use your 401(k) to pay down a debt with a high interest rate, and you know you will stay at your job, a 401(k) loan could work out. But, this should really just be a last resort measure if you have no other good options.
- SmartMoney: Tapping Your 401(k) Before You Retire
- CNN Living: Should I Cash Out My 401k?
- SmartMoney: Should You Borrow Money From Your 401(k) or 403(b)?
- The Motley Fool: Nine Ways to Pay Off Debt
- MSN Money: Warning: 401(k) Loans are Hazardous to Your Wealth
- IRS.gov: 401(k) Resource Guide - Plan Sponsors - General Distribution Rules
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