If you’re deep into debt and not sure where to turn, borrowing from your 401(k) could be tempting. It’s a pot of money not tied to a nerve-racking application process, scrutinizing lenders or credit score requirements.  

Easy choice, right? The reality may not be so simple. Let’s start with the basics.

How does a 401(k) loan work?

Some retirement plans may offer loans, and borrowing from your 401(k) is relatively simple. There’s no bank giving the go ahead, and the funds will likely end up in your hands quickly. Laws govern what qualified plans will allow you to borrow. According to irs.gov, if you have a vested balance more than $10,000, you can borrow up to 50 percent or $50,000, whichever is less. Some plans make an exception for balances less than $10,000, allowing a loan of up to $10,000. Translation: Depending on your balance, you can access a fair amount of money quickly. Find out how much your 401(k) is worth.

Paying it Back

When it’s time to pay up, it’s important to be sure your income can support paying back the loan. Payments are generally taken directly from your paycheck — with interest, paid back to yourself — on a set schedule, generally within 5 years. Calculate your estimated take-home pay minus the repayment and determine whether it’s enough to live on. If you’re looking at your retirement money to address debt in the form of an outstanding loan, that might not be the case.

The typical 5-year repayment schedule can fluctuate based on factors including what the loan is used for. A notable exception is using a 401(k) loan to purchase a primary residence.

One caveat: That payment schedule assumes you’ll work for your current employer throughout the term of the loan, or until you’ve paid back what you took. If you leave your job, you could be required to pay back the balance within 60 days. Translation: If the money is gone — put toward your debt — you may end up worse off than you started with a 10% early withdrawal tax.

Time to do some soul searching. Are you happy with your job? Is your employer happy with you? If you’re unsure about your future plans or if layoffs have plagued your company or industry in the past, think twice.

But if you have secure, steady income, you’re happy and performing well in your job and your income supports paying back what you take out, you can consider borrowing from your 401(k).

Now that we know what a 401k loan is — and isn’t — is borrowing from a 401(k) to pay off debt a good idea? In most cases, it’s not.

You lose tax deferment. The beauty of contributing to a traditional 401(k) lies in avoiding paying taxes on that money until you cash in. To pay back your 401(k), you use taxed income that will be put back into the plan, then later taxed upon withdrawal. Ouch.

Your money loses its protection. In general, money ear-marked for retirement is protected from creditors and bankruptcy should you run into financial trouble. If you’re in serious trouble and hoping your 401(k) loan will bail you out, have a solid plan in place for not ending up behind on your bills.

You’re borrowing from your future self. While you have an outstanding 401(k) loan, you most likely won’t be able to continue regular contributions. Getting stuck in a cycle of paying back what you’ve taken out means potentially reducing or delaying your retirement payout.

Time is on your side. A 401(k) loan favors borrowing a smaller amount you’re confident can be paid back quickly. That limits the risk of not paying back on time and minimizes the impact of pausing regular contributions. Use our calculator to find out how long it’ll take to pay off your loan.

It should be your last resort. While a 401(k) loan can be beneficial for someone in good financial standing who needs liquid assets quickly, it’s a slippery slope for someone in debt. If bill collectors are knocking and the phone won’t stop ringing, first see what you can do to ease the pressure. Work to set up a payment schedule and create a budget and put yourself on track to make a dent in what you owe.

Protect yourself now, and in the future. Talk to your FBFS agent about your retirement goals and how we can help you achieve them.

 

Sources:

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans