Paying Off Debt With A 401k Loan

If you've considered paying off debt with a 401k loan I urge you to think again. Despite the many advantages this option offers, there are some heavy downsides that need to be carefully considered.

Obviously there are some upsides to taking this option, or so many people wouldn't be doing it. The best of the upsides are that you have a very low interest rate, and that the interest you do pay goes back into your retirement savings account. When you have no other source of funding this is also definitely preferable to making an early withdrawal from your account.

When you make a withdrawal before reaching retirement age you have to pay taxes on your withdrawal plus a ten percent early withdrawal penalty, which can easily total up to thirty percent or more of your retirement savings. This is a lot of money to lose and means you'll have a much smaller nest egg.

If you decide to take a 401k loan then you have five years to repay the money you've borrowed, and if you fail to repay it in time the balance is treated as though you cashed out, meaning you owe the taxes and the ten percent withdrawal penalty. If you lose your job, or quit your job, during the time you are making your payments the balance becomes due and you have a short period of time, approximately a month, to repay the balance in full or it is treated as though you cashed out in the first place.

For these reasons this is something that's only recommended you do if you have no other option for funding. For something like paying off debt, which you could do through normal payments, it's not worth the risk. Yes, you could have a lower interest rate, which you would be paying into your account, however that interest rate could rise dramatically if something unexpected occurs and you have to treat your 401k loan as though you cashed out and you lose a great deal of your money to taxes and that ten percent penalty.

Because of these high risks for something like paying off debt it's not recommended that you take a 401k loan.

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Are 401k Loans A Good Idea?

Are 401k loans a good idea? No, not really, but they may still be your best option in certain situations.

Until you reach retirement age, 59 1/2 years old, there is a large penalty for withdrawing from your retirement account. If you take an early withdrawal you have to pay federal taxes, state taxes, and a ten percent penalty.

One way to avoid this and still take advantage of this money you've saved is to take a loan from your 401k, this is not available for everyone but some companies have worked it into their plans. There are a lot of downsides to doing this, however.

First of all, and this is often overlooked, the money you've borrowed isn't being invested anymore. If you leave the money where it is in your account then you can keep earning returns on it, but while you've been borrowing it the money isn't earning you more for your retirement.

You have five years to repay the loan, period. If you haven't finished repaying it at that time then the remaining balance is treated as though you had cashed out in the first place, and you'll then be charged taxes and the ten percent penalty on those funds.

Also, if you lose your job the balance becomes due and you're typically given somewhere between one to two months to finish repaying the loan. If you don't, then the balance is treated as though you cashed it out originally, and you'll be charged the penalty and taxes on whatever you can't repay.

On the upside, however, the internet on a 401k loan is very low compared to any of your other borrowing options, and the interest you pay goes straight into your retirement plan, so you're paying the interest to your future self instead of a company. This is a big plus, and a large part of why so many people decide to take the risk.

If you feel you have no other option except to cash out your retirement account than borrowing instead and trying to make payments is certainly a better option for you, but if you have another option for getting funds I'd definitely recommend considering that first.

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