Borrowing from 401k for paying existing debt might come under your consideration if you have a huge financial burden because of credit card debt, medical bills or other debts. When a job loss, or wage cuts, leaves you with little choice in how to survive you may want to consider every possible sources of funds to pay off debt.
401(k) plans, which were originally devised to fund future retirement, are one of these sources. While the urge is there to tap into this retirement plan loan, be aware that there are many factors to take into account and that you should make accessing these funds a very last resort. Here are pros and cons of borrowing from your 401k to pay off debt.
Pros of Borrowing from 401k Loan
A low-interest loan can be taken on the account up to fifty percent of the vested balance up to fifty thousand dollars. The repayment length is sixty months, as long as your are employed continuously.
You can take the loan without a credit check and has no qualifications, offers an interest rate that is typically prime plus a few percent. The forms are usually simple and loan approval is quick. Although you pay interest, this interest is credited to the account.
Cons of Borrowing from 401k Retirement Plan Loan
Even though eighteen to twenty-one percent of workers with 401(k) plans have taken out loans against those funds, in just about every case these are people who have exhausted every other option. The risk for these people is tremendous.
If someone has a loan out against their policy and is handed a pink slip they often have only two months to repay the loan amount in full or they must pay taxes on the withdrawn amount even though they intended it to be a loan, not a withdrawal. These tax fees are as well as a ten percent penalty tacked on to the money for removing it from the account before retirement age.
The cycle is harsh, needing to pay the penalties on the loan amount can cause the entire 401(k) to be cashed out and the rest used to pay extra penalties. The eventual long-term result is that the entire retirement fund is lost.
Borrowing from 401k Loan Versus Other Debt Relief Options
If the above risk is not enough, consider that a 401(k) plan in repayment cannot actually expand in value. There is no way to give more money to it while making payments on the pension plan loan. As many as five years of tax-free contributions is lost while the loan is being repaid. Interest that would have earned on that money is lost as well.
If you are in a real hard place with your debt and have looked into all the other options –including borrowing against home equity, selling off personal items, or working with a debt counselor– and cannot find another way out, you might wish to consider filing bankruptcy before borrowing from 401k retirement funds. The law protects these accounts from creditors.
All in all, borrowing from the 401k retirement plan loan should be the last thing to do. And if you do want to withdraw money from your 401(k) make sure you’ve compared interest costs versus tax penalties in interest saved before deciding whether it will save you money.