If your budget is getting hammered by high interest credit card debt, borrowing from your retirement savings may provide a solution. Pay off credit card debt with your 401(k), and you could save a substantial amount of money.
Assuming you have credit card debt with a high interest rate, using your 401(k) loan provision is a great idea to save on interest and pay down debt.
Robert Riedl, Director of Endowment Wealth Management
To determine if this debt solution is right for you, keep the following 401(k) loan facts in mind.
Know your 401(k) plan
First, determine if your 401(k) plan has a loan provision. Find this information by checking your plan documents or by consulting with the administrator to see if they permit borrowing, and for what reasons. Determine if you’re able to pay off credit card debt with 401(k) savings.
Also, check to see how much you can borrow from your 401(k). According to the IRS, the maximum amount you can borrow is equivalent to 50% of your vested account balance or $50,000—whichever is less. If you have less than $10,000 in vested funds, then you may borrow up to that amount. Vested funds are the funds you currently own in your account. Your contributions are always 100% vested, but it can take years for employer contributions to become vested. How long depends on vesting requirements of your plan. Some retirement plans also have a minimum loan amount.
According to the IRS, the maximum amount you can borrow is equivalent to 50% of your vested account balance or $50K.
The loan from your retirement account must be repaid within five years, and payments must be made at least quarterly. Many employers require that you make payments with payroll deductions. As you pay, you receive statements showing your remaining principal balance. There are no prepayment penalties when you borrow from your 401(k).
Benefits of Borrowing from Your 401(k) Plan
Consider the following benefits of borrowing from your 401(k) to pay off credit card debt.
Enjoy interest savings
The biggest benefit you’ll experience when you pay off credit card debt with a 401(k) loan is what can amount to substantial interest savings, says 401(k) advisor Timothy Yee, chief retirement specialist and co-founder of Green Retirement, Inc.
A 401(k) typically has an interest rate of Prime, Prime + 1%, or Prime + 2%. This can translate to a loan rate in the 3.5% to 5.5% range, which can be attractive, compared to high interest rate credit cards. Interest on the 401(k) loan is also paid back to the employee’s 401(k) account, whereas credit card interest goes to the credit card company.Timothy Yee, Chief Retirement Specialist, Green Retirement, Inc.
The interest savings can be substantial, agrees Riedl.
“For instance, if you borrow $20,000 and the interest rate in your 401(k) is 4%, your five-year monthly payment would be approximately $368. If your credit card interest rate is 24% and the average monthly interest expense is around $400, with no debt reduction, then the interest rate savings alone will allow you to pay off the 401(k) debt within five years. This is something you could never accomplish with credit card debt of 20% plus.”
Not all 401(k) plans allow it, but if yours does, borrowing is a much simpler process than getting a loan from another source. There’s no need for a credit report and no impact on your credit. The application is usually short and simple. You contact your 401(k) provider and request it. If your request falls within the plan’s rules, you can often get your money quickly and easily.
Pay no tax or interest
You won’t be charged tax for borrowing from your 401(k). There’s also no real interest charged. You pay any interest charged on the outstanding loan balance back to yourself when you repay the loan. This makes the cost of a 401(k) loan minimal and substantially less than the cost of a bank loan.
Drawbacks of Borrowing from Your 401(k) Plan
Take the following into account before borrowing from your 401(k).
Potential penalties if you quit or lose your job
If you borrow from your 401(k) and then leave your job, either of your own free will or because of termination, you must pay back the entire outstanding balance within 60 days. This could become a problem if you planned on taking five years to repay the loan. It’s particularly problematic if you lost your job and income source.
Whatever amount you aren’t able to pay back to the retirement plan will be considered a retirement distribution. If you’re younger than 59 ½, you’ll have to pay income tax and a 10 percent early withdrawal fee on the money.
Possible inability to make contributions
While you’re repaying your 401(k) loan, you may not be allowed to contribute to your plan. If your employer doesn’t permit pre-tax contributions, you lose the benefits of saving money. This may also mean that your income taxes rise.
Loss of investment growth
A downside of taking out a loan on your 401(k) is losing investment income from the money you withdrew, which is often referred to as opportunity cost.
“You can miss out on possible market growth,” says Yee. “For example, the Dow Jones finished 2016 up 14%.”
Keep in mind that when you pay off the loan on schedule in five years or less, this short-term loan has limited impact on your overall retirement savings.
Alternatives to using 401(k) to pay off credit card debt
Rather than raiding your retirement plan, you may be better off going with an alternative. Two choices that work well are personal loans and 0% balance transfer cards.
Personal loan. If you have good credit of +640, you might be able to get a personal loan with a low interest rate. Keep in mind that this option requires that you make monthly payments, so be certain your budget allows for this.
0% balance transfer card. Some credit card companies offer an introductory rate of 0% that can last for 12 to 18 months. This will give you time to pay off the loan before interest kicks in. For such a card, you require excellent credit and must pay a balance transfer fee of what is usually 3%.
The Bottom Line
Borrowing from your 401(k) may provide you with a low-cost, convenient way to climb out of credit card debt. However, personal loans and balance transfer credit cards are also good options that avoid some of the downsides of raiding your 401(k).
To determine how your 401(k) plan stacks up against others, check out this SuperMoney blog post.