In this step-by-step guide you will be able to determine your risks, the impact on retirement (could be good or bad), how much money you will pay in interest to your creditors versus your return on your investments, and how much you will save off of your monthly expenses by borrowing from your 401k.
Most financial professionals will warn you vigorously to stay away from your 401k. Your 401k’s true purpose is for your retirement. However, from time to time, throughout your life, on your way to retirement, you may find yourself in a situation where you start thinking about using your 401k.
I generally agree with them, but what if you’re in a situation where your monthly expenses are out of control and you can’t qualify for a traditional consolidation loan? What about when you’re behind on your bills and desire to avoid bankruptcy or you’re faced with a Chapter 13?
If you find yourself in any of these situations, you’re probably tempted to borrow from your 401k. From a reactionary standpoint, I get it. You have a problem and a potential means to resolve it.
However, there is a good possibility, if you take the time to learn about the impact that a 401k loan will potentially create for you, that you may change your stance on acquiring one. 401k loans aren’t for everyone. In fact, they’re quite situational.
Your First Consideration…
If you’re in a situation where you’re contemplating a withdrawal rather than a loan, take pause and do some math. When you withdrawal the funds, you have to pay State and Federal income taxes and a 10% penalty on the amount you withdrawal. You will also sacrifice the amount you withdrawal from your retirement. Withdrawals, plain and simple, are a bad move and should only be exercised in the most extreme circumstances.
Here’s an example…
$25,000 Withdrawal from 401K
- Penalty: $2,500
- Federal Income Tax at 25%: $6,250
- State Income Tax at 8%: $2,000
- Total Taxes and Penalties: $10,750
- Monthly Payment: $0
As you can see, a withdrawal in these circumstances results in an immediate 43% loss to you. And since you withdrew it, you’re not committing yourself to replenish it, which could come back to haunt you down the road in your retirement years.
$25,000 Loan from 401k
- Penalty: $0
- Federal Income Tax: $0
- State Income Tax: $0
- Total Taxes and Penalties: $0
- Monthly Payment: $471.78 (at 5 years and 5% interest)
There are two things that can cause a 401k loan to convert into a withdrawal, and, in turn, expose you to the taxes and penalties. The first way is if you default on the 401k loan. Most 401k loans will convert to a withdrawal if you miss 3 consecutive monthly payments.
The second way is not applicable to everyone. Some employers require a 401k loan to be paid back 60 days after job separation.
So if your employer employs this policy and you quit or lose your job, you will have 60 days to pay back the entire balance. If you fail to, which you more than likely will, the remaining balance of the loan will convert to a withdrawal and you will be exposed to the taxes and penalties. Not to mention the severe hit to your retirement savings.
Your Second Consideration…
Based on the above information, if you’re considering borrowing from your 401k, the first thing you should do is call your 401k administrator and ask them about your employer’s policy in regard to job separation.
If they require the balance of the loan to be paid back within a short period of time, borrowing from your 401k is a very dangerous maneuver.
If they don’t require the entire balance of the loan to be paid back after job separation, the only way to default and subject yourself to the taxes and penalties is if you miss a certain amount of payments in a row. Be sure to inquire on how many payments that is for you specifically when you call the 401k administrator to make your inquiry about their job separation policy.
- Another important consideration to make is that you also don’t want to borrow from your 401k if you can obtain a reasonable consolidation loan. There is no logical reason to expose yourself to the risks of borrowing from your 401k if you can avoid doing so.
- If you’re behind on your bills and feel bankruptcy makes more sense, please know your 401k is protected from your creditors. Meaning, if you would prefer the option of bankruptcy over the risks of a 401k loan, you should call a bankruptcy attorney.
- If you prefer to avoid bankruptcy or if you’re faced with a Chapter 13 bankruptcy, you may find it beneficial to borrow from your 401k to settle your credit card debts.
If you feel that settling your debts will be necessary in order to solve your entire problem, please don’t jump in head first. Please refer to the description of my service to gain a better understanding about my debt settlement services.
Borrowing from a 401k – How to make sense of it
The way to determine if a 401k loan makes sense for you and your situation is to figure out 4 things.
- How much will it reduce your monthly expenses by?
- What’s the difference that you will pay in interest to your creditors versus the gains you would achieve with your investments?
- What’s the impact on your retirement savings?
- What are the risks?
It is unwise to blindly borrow from your 401k without making these calculations.
It is unwise not only from the perspective of the damage you could wreak on your future, but also from the perspective of the wealth you could build.
In the most ideal situation, the end result of borrowing from a 401k is…
- Consolidated debt
- Lower monthly expenses
- Greater discretionary income
- Potential for greater savings at retirement – With your freed up discretionary income, you will have the option to contribute additional funds to your retirement.
- Wealth preservation – Since the interest is paid to yourself instead of your creditors. This is true when the interest rates you’re currently paying are more than the investment returns you’re achieving through your 401k – e.g., if you’re paying 21% interest on your credit cards and achieving a 9% return from your funds in your 401k.
- Higher credit score – Due to the debt to credit limit ratios and the decrease in total outstanding debt after the debts are paid off via the 401k loan. These two aspects are responsible for 30% of your credit score (according to FICO). And if your accounts are delinquent and you’re able to resolve all of them, it will put you in a position to where lenders will be more apt to lend to you (because all of your delinquencies are resolved), and, in turn, this will generate the opportunity to rebuild your credit score over time. Please see Credit Scores when Paying or Settling Collections & Charge Offs for more information.
- Lower costs on insurance and loans (due to the higher credit score)
Once you have determined the job separation issue, I invite you to follow these 4 easy steps that will help you make the necessary calculations to determine if a 401k loan makes sense for your situation.
- Step One – The impact to your monthly budget
- Step Two – How much interest will you pay on the debts you want to consolidate versus your return on your investments?
- Step Three – Impact on retirement savings
- Step Four – Consider the risks