More than half of Americans, participate in their company’s retirement plan. As of 2019, this equates to more than 77 million people.

One of these people (a client of mine), recently asked if it was smart to use their 401(k) as a loan option. More specifically, it was a case where the options were:

1. pay off credit card debt with a 401(k) loan, and continue to save/invest (in IRAs, etc.), or
2. continue to pay off credit card debt with any available cash flow, and wait to add to savings once the debt is eliminated.

As a rule, I advise people to NOT touch their retirement accounts until (shocker here…) retirement. I encourage them to act like the funds are not there for the taking, and not accessible for short-term needs. However, certain circumstances may call for people to consider when a 401(k) loan makes sense.

Ironically, while this is called a “loan” there is no lender! It’s really just the ability for you to borrow from your account, and you pay yourself back with interest.

That said, let’s get into it a bit.

How 401(k) Loans Work

First off, your options will depend on what your particular plan allows. If loans are allowed, they are typically limited to $10,000 or 50% of your vested balance (if higher), but no more than $50,000. An interest rate is established, and you are required to pay (yourself) back typically from paycheck withholding.

In general, a 401(k) loan needs to be paid back within 5 years. But if you leave your job, you would have to repay it sooner. If you don’t repay – the loan amount could be subject to taxes and penalties.

WARNING: Studies show that more people do NOT repay their loans than ones that do. Many leave their employer before it’s paid back, and approximately 10% downright default (on themselves!).

If all goes well and you repay the loan, you essentially have restored the value of the account. This is different than a straight-up “withdrawal”, which is gone for good once removed.

Here are some situations to consider:

If you have high-interest debt. Typically credit card interest is higher (say 10-15%) versus a 401(k) loan (say 5-6%). In this case, taking a 401(k) loan to pay it off could be a good idea. I wouldn’t say it’s the best option, so make sure you’ve reviewed your other options first. In other words, can you temporarily cut out some other expenses? Have you exhausted your other savings? Can you make some side hustle instead?

Assuming you have done that homework, then using the 401(k) loan could be good because 1) the loan rate is likely to be lower than the rate of your other debt, and 2) you pay the 401(k) interest to yourself (not someone else).

If you have a financial emergency. In a dire situation and need money for something quickly? The 401(k) loan option could work because 1) you can get the funds fairly quickly, 2) you don’t need to be approved (ie. no credit check), and 3) a relatively low-interest rate that you pay back to yourself.

I wouldn’t say it’s an overnight process, but funds may be accessed within a week or so…generally. It would be advisable to know what your plan rules say (if they allow loans at all) and what their timeline looks like.

Consider your entire financial picture. An obvious question to ask yourself before embarking on a 401(k) loan: do you expect to leave your company anytime soon? If so, steer clear of this option (taxes will be due and a 10% penalty for those under age 59.5 if the loan isn’t repaid).

It’s also worth exploring if there are other low-cost options available to you. A home equity loan, for example, might be reasonable. A 0% balance transfer card would be a solid option. Got any family members who would be willing to offer you funds at a favorable rate? 

Other “cons” of tapping into a 401(k) loan. Be aware that the 401(k) interest you pay is not deductible (compared to a home loan or student loan, which could be deductible). Also, the money taken out may miss out on future market appreciation. So the 401(k) might not grow as much as it could have prior to the loan.

One last thing worth mentioning is the 401(k) is generally protected from creditors. In the event of a lawsuit or a lender getting a judgment against you, your 401(k) is protected from this type of situation. They can come after your other sources of assets but the 401(k) has certain layers of protection within it, if that is a concern.

In the end, and 401(k) loan should be considered as one of the last resorts to tackle debt. While it might not be the WORST solution, it’s probably not the most ideal. But one would have to consider it if all other options were exhausted. Talk to a professional about the pros/cons of your specific situation.

Brandon

Risk Disclosure: Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance does not guarantee future results.

This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. The content is developed from sources believed to be providing accurate information; no warranty, expressed or implied, is made regarding accuracy, adequacy, completeness, legality, reliability or usefulness of any information. Consult your financial professional before making any investment decision. For illustrative use only.