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 or withdrawal will potentially create for you, that you may change your stance on acquiring one. 401k loans or withdrawals aren't for everyone. In fact, they're quite situational.
Your first consideration... borrow or withdrawal?
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 if you're not older than 59 and a half, 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)
Typical 401k loan terms...
- Loan amount
The amount you will need to pay off your debt. You're generally able to borrow 50% (up to $50,000) of your 401k balance.
- Interest rate
Most rates today range from 3-5%.
- Length of loan
They generally range from 12-60 months.
I recommend 60 months so you have the lowest payment possible. This way, if life throws you a curveball and your income takes a hit, you will be more likely to continue to afford the payment, as you may always pay more toward your loan to pay it off sooner. A good example would be to get a 5-year term but pay the 2-year payment. This way, if something happened to your income, you would only have to pay the 5-year payment amount during your time of financial crisis.
Your second consideration... how your loan can convert into a withdrawal...
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.
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.
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 quickly.
If you feel settling your debts will be necessary, please don't jump in head first. Please refer to my 4-part series about debt settlement to gain a better understanding about how debt settlement works.
Borrowing from a 401k - How to make sense of it
When speaking with your 401k administrator, make sure to figure out at least these 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)
- Again, if you lose your job while your loan is outstanding, you may have to repay the loan back within 60 days of job separation. If you're unable to do so, your loan will convert to a withdrawal and become a penalized and taxed event on the remaining balance of your loan at the time of default.
However, some employers will allow for the continuation of the loan after job separation, so it's 100% CRITICAL to inquire on your employer's policies regarding this prior to making your loan.
- If you default on your loan, it will convert to a withdrawal, and if you are younger than 59 and a half, you will have to pay a 10% penalty, along with State and Federal income taxes on the remaining balance of your loan at the time of default.
A 401k loan is generally considered to be defaulted when you become delinquent on your payments for 90 days. However, this can differ depending on your plan, so please consult your 401k administrator for your plan's specific details.
- If you get hurt or become seriously ill during your repayment of your 401k loan, you may not be able to continue to pay the payments and you may default on your loan and be subjected to taxes, penalties, and a significant loss to your future retirement savings.
You may find it beneficial to speak with your employer about any possible disability insurance that they may offer. You may also want to check into disability insurance from AFLAC.
- Another risk you should consider is running up your debt again.
If your credit lines are still open when you payoff your debt, your credit lines will be freed up and available. If you borrow from your 401k, it is highly advisable, going forward, to remain disciplined and only utilize unsecured credit when necessary.
It is very important that you are 100% confident about the affordability of the 401k loan payment.
If you're uncomfortable with any of the risks, you should not borrow from your 401k.
I strongly recommend prior to borrowing from your 401k that you meet with your retirement advisor to have your individual circumstance reviewed by a professional.
I hope this article helps you better understand your decision about borrowing from your 401k to pay off debt. Please feel free to contact me directly with any questions.