Is it a good idea to use a 401(k) loan to pay off your credit card debt?

Under rare circumstances, it could be a good idea to use a 401k loan to consolidate credit card debt. But generally, it’s not a good idea. 

Why is raiding your retirement account a bad idea? Because by doing so, you jeopardize your financial future, which could lead to serious regrets. What should be your golden years could turn out to be bronze at best. And, by the time you realize that you may find that your age – or age-related health issues – is a barrier to earning the money you need to make your retirement comfortable.

What is a 401k loan?

A 401k loan is a workplace retirement plan that allows you to save and invest in a tax-efficient way.

According to the U.S. Census Bureau, 34.6% of Americans have 401k-style retirement plans. That means about two-thirds do not. Getting a 401k loan is not an option if you don’t have a 401k.  

Whether you are permitted to borrow against your 401k is up to the employer who sponsors the plan. So, if you’re enrolled in a program, you need to check whether this is an option.

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Pros and cons of using your 401(k) to pay off debt

Pros

• Fast funding: Many 401(k) loans get funded within a week or two. 

• Lower interest: The interest rate on a 401(k) loan is often 1-2% above the prime rate. If the prime rate is 8%, your interest rate could be 9-10%. In contrast, the interest rate on a credit card is typically 10-20% above the prime rate. 

• No credit score requirement: There is no minimum credit score required to borrow from your own 401(k).

• No credit score hit: There is no hard inquiry into your credit when you borrow from your 401(k), so you won’t experience the credit score drop typically associated with loan applications. 

Cons

• Less for retirement: Borrowing from your 401(k) means you'll miss the opportunity to let that money grow. The most valuable factor in retirement savings is time. Each dollar you take out has to start over when you pay it back. The interest you pay on the loan may help you make up for some lost growth. 

• Tied to your employer: Your 401(k) lives with your employer. Many 401(k) loans come with a requirement that you repay your entire outstanding balance if you separate from the company for any reason. Typically, you have 60 days. If you can’t pay it back that fast, it’ll be treated as taxable income.

• Tax consequences: You funded your 401(k) account with pre-tax money. But you’ll have to pay the loan back with money that’s taxed.

Big benefits of a 401k loan

If your employer allows loans, there are a couple of big benefits.  

First, you’ll likely get a low interest rate compared to most other loans. 

Secondly, few employers carry out credit checks before approving a 401k loan. Why should they? You’re borrowing your own money. They also don’t generally report loan repayments to credit bureaus, so your credit report and score should be unaffected if you make late payments. Also, you probably won’t be charged late fees.

By now, you’re probably sold on the benefits of a 401k loan. But don’t get too excited until you read about the potential downsides we cover below.

How does a 401k loan work?

The IRS gets a big say in how 401k accounts run, and that authority extends to 401k loans.  Your employer can’t vary the IRS’s rules but can add its own on top of them. It’s up to you to find out your employer’s rules, perhaps by asking a retirement plan specialist in your human resources department to advise you.

First, a loan is not a distribution. Distribution occurs when you permanently withdraw funds from your 401k. If you do that before you’re 59½ years and absent a verifiable hardship, you’ll have to pay income taxes on the withdrawal plus a 10% early withdrawal penalty. 

The amount you can borrow

Assuming your plan allows it, the IRS has no objections to your borrowing from your 401k. However, there are limits on the amount you can take out.

If your 401k balance is $20,000 or less, you can borrow up to $10,000, provided your account contains that much. If your balance is above $20,000, you can borrow 50% of that balance. But you can’t borrow more than $50,000, no matter what.

You can have multiple loans from the same account at the same time. However, the balance of both loans combined must be lower than 50% of your total balance, up to $50,000. The formula can be complicated, so check out the IRS’s podcast and transcript that walk you through it. 

Repayment terms: length and interest rate

The IRS caps the term (length) of a 401k loan at five years. If you take longer to repay it, the outstanding balance on the loan after five years will become a deemed distribution. In that case, you’ll owe income tax on that amount and the early withdrawal penalty if it applies.

The five-year term is a maximum. You may choose a shorter period if you can repay your loan faster. The shorter the loan period, the less interest you’ll pay and the sooner you can return to earning money on your retirement savings. 

If you separate from your employer during the repayment period, your employer may require immediate repayment of the full outstanding balance.

The interest rate on a 401k loan is typically 1-2% above the prime rate. For comparison, a typical credit card interest rate is the prime rate plus 12-20%. The interest rate on a credit card is variable and can change, but the rate on a 401k loan is fixed for the life of the loan. Your employer can tell you about the rate that applies to your plan.

How does a 401k hardship withdrawal work?

If you have a verifiable hardship, you might be able to take money out of your 401k account. There are strict rules about when you can take a hardship distribution. The financial need must be immediate and heavy, and you can’t have other assets that would satisfy it. Medical bills, death and burial expenses, and purchasing your first home are all examples of situations that might qualify for a hardship withdrawal. You can find more details on the IRS website. Note that your employer is not obligated to recognize every hardship the IRS describes. 

A hardship withdrawal permanently reduces the value of your retirement account. It’s not a loan, and you cannot repay it. Your future contributions to your 401k account will be subject to regular annual limits. 

401k loan costs 

401k loans are not free. The cost is similar to that of other loans. You might pay an origination fee or ongoing loan maintenance fees. You will also pay interest, although this money will go to your own account. The exact cost varies and will be determined by your employer or the plan administrator. 

The highest cost of a 401k loan is the loss of compound earnings over time. It can be hard to calculate that figure because you can’t know how much your money will be worth when you retire.

Despite the costs, there are some times when a 401k loan might be a good idea.

Reasons to use a 401k loan to pay off credit card debt

Borrowing from your 401k can be an attractive option because:

1. The interest rate is low compared to credit cards, which might allow you to pay off the debt faster

2. No credit check when you apply

3. No late fees

4. Late payments don’t affect your credit score

5. Fixed interest rates

Risks of taking a 401k loan to pay off credit card debt

The biggest risks of all 401k loans are:

• Missed investment opportunities #1 – The money you owe on your 401k will no longer be invested. So you’ll miss out on all the dividends and capital gains you’d otherwise have acquired if you had let that money sit in the account.

• Missed investment opportunities #2 – Some employers don’t allow you to contribute to your plan while a loan is outstanding. And that means even more missed opportunities to build your retirement savings.

• Repayment requirement - If you separate from your employer for any reason, they may demand immediate repayment of your entire 401k loan.

• Taxes and penalties - Should you fail to repay your loan within the time limit or make too many late payments, your 401k loan may become a “deemed distribution,” meaning you could face a big tax bill from the IRS and a 10% penalty fee levied by your plan.

• Loss of tax advantage - You’re borrowing money on which no tax has been paid but are repaying it out of taxed income. You’ll also pay tax on distributions when you’re older. So, you’re turning part of your 401k from tax-efficient to tax-inefficient.

Of course, none of this means it’s always wrong to get a 401k loan. For example, if your credit score is low and your credit card balances are high, one of these may be your only way to borrow money and restore financial order to your life. But it’s probably a good idea to explore alternative loans first and use one if you can.

Taxes on 401(k) loans

A 401(k) account is a tax-advantaged account. You don’t pay taxes when you put money in. In retirement, you’ll pay regular income taxes on your withdrawals. 

Taking a 401(k) loan means you’ll be double-taxed

When repaying a 401(k) loan, you use after-tax money from your paycheck. Then later when you retire and withdraw that same money, it gets taxed again as income. 

401(k) loans come with the risk of an early withdrawal penalty

If you don’t pay back the loan, or if you separate from your employer and you can’t afford to pay it back by the deadline, the loan will be treated as a taxable withdrawal by the IRS. If you’re under 55 1/2 years old, you will likey have to pay a 10% early withdrawal penalty. 

You might miss out on tax-free growth

The money in your 401(k) grows tax-free until you withdraw it. If you take money out, you’re permanently removing the option for those dollars to grow. This loss could be partially offset if you pay interest on your loan (that money goes straight back to you in your account). But the most valuable part of your 401(k) account is time. It may not be possible to experience as much growth as you would have if you hadn’t taken out the loan.

Alternatives to a 401k loan

Here are some alternatives to 401k loans for consolidating credit card debt,  

1. Debt consolidation loan – Often open to those with lower credit scores

2. Home equity loan – Available to homeowners with sufficient equity

3. Balance transfer credit cards – Available if you qualify for the offer. The low rate will expire after an introductory period.  

4. Tapping your emergency fund or other savings and selling assets

It’s a good idea to inquire with several lenders to find the lowest rate available, but use lenders that do a soft pull on your credit. If you apply with multiple lenders, your credit score will likely take a hit.