Can or Should You Use Your 401(k) to Pay Off Debt?
In addition to potentially facing tax penalties if you can’t pay your 401(k) loan back on time, you risk hurting your retirement saving progress.
April 15, 2021
If you’re in debt, you might be pretty eager to not be in debt anymore. And if you’ve been diligently saving for retirement, you might question keeping money in a 401(k) or if that money might be better used to help pay off your debt. The temptation to borrow money from a 401(k) to pay off debt might be an appealing option if your debt is accumulating interest and becoming difficult to climb out of, which might be the case if you’re dealing with high-interest credit card debt. It’s your money, after all — shouldn’t you be able to use it to take some financial stress off your plate?
If a 401(k) loan is something you’ve been considering, let’s pause for a moment and take a closer look at what it’s like to borrow from this retirement savings vehicle and if doing so is a good idea.
Borrowing From 401(k) to Pay Off Debt
In some cases, you can use your 401(k) to pay off credit card debt or other types of debt. The catch is, this decision isn’t fully yours to make. The ability to borrow money from your 401(k) isn’t a guarantee and depends on the rules set for your plan, but some do permit participants to borrow money from their account balance.
It’s up to your plan sponsor to decide if they want to allow 401(k) loans, as allowing this isn’t something they are required to offer. If you’re not sure if your plan permits 401(k) loans, you can check in with your plan sponsor or review your Summary Plan Description. If your plan does allow 401(k) loans and you decide to pursue this option, you typically need to apply for the loan and meet certain requirements. You’ll want to check with your plan administrator about the process of taking out a 401(k) loan.
401(k) Loan Rules for Participants
Borrowing money from your 401(k) isn’t as simple as making a withdrawal from your account, since these loans come with a handful of rules you’ll need to comply with. When you take a loan from your 401(k), you’ll need to repay the loan with interest. If you don’t repay the loan, those unpaid amounts are then considered a plan distribution. If this distribution is considered an early distribution, you may face penalties, so it’s important to make a plan for paying back the loan so you won't incur penalties. Typically, early 401(k) distributions need to be included in gross income on tax forms, and you might have to pay an additional 10% early distribution tax if you're below the age of 59 and a half, and don’t qualify for any early distribution exceptions.
The interest you’ll pay on the loan will be determined by the terms set for the loan by the plan provider. If you’re not sure how long you’ll be working at the job providing you with your 401(k) plan, you may run into trouble. If you leave your job before you can pay back the loan, your plan sponsor may require you to repay the loan back in full.
Repayment periods can vary, but generally, you need to pay back a 401(k) loan within five years and make quarterly payments throughout the life of the loan. If you use the 401(k) loan to purchase a primary residence, this five-year timeline doesn't apply.
Should You Use Your 401(k) to Pay Off Debt?
The answer to this question will vary depending on a person's financial situation, and there are both pros and cons to using a 401(k) loan to pay off debt. However, if you’re looking for guidance on whether or not to take out a 401(k) loan, the IRS recommends working with a financial planner to help decide if a 401(k) loan is your best option for paying down debt or if you should pursue loan options from other sources, such as a financial institution.
Depending on how much debt you have, a 401(k) loan might not be able to provide a full solution to your debt, which may leave you struggling to pay off the remainder of your debt and your 401(k) loan. The maximum 401(k) loan amount you can borrow from your plan is either 50% of your vested account balance or $50,00, whichever amount is less. If your vested balance is less than $10,000, you can borrow up to that full $10,000 if your plan permits it.
When deciding if you should use a 401(k) loan to pay off your debt, it’s important to fully understand what the implications of such a loan might be. Take note of what your interest rate will be, as well as your quarterly payment amounts. Can you afford to make your payments?
You’ll also want to take into account how borrowing money from your 401(k) will affect your retirement savings and plans. In addition to potentially facing tax penalties if you can’t pay your 401(k) loan back on time, you risk hurting your retirement saving progress. Understanding if you’ll be able to repay your loan goes hand in hand with planning your retirement, as any unpaid loan amounts lead to less money saved for your retirement. While being debt-free has its perks, letting your retirement savings continue to grow and gain interest in a 401(k) also has its benefits.
Think carefully before disrupting your retirement plans to tackle your debt. At the end of the day, it may not be financially worth it.
If you want to let your 401(k) grow undisturbed, consider using Tally to help you pay down your debt, while reducing financial stress at the same time.