Some 401k programs let you borrow against the money you’ve accumulated in your 401k. Generally speaking, the programs allow you to borrow up to 50% of your vested account balance, or $50,000 — whichever is less. You then pay yourself back with interest, which seems like a great idea. After all, why pay creditors interest when you could be paying that money to yourself instead? Well, there are a couple of very good reasons why doing so isn’t smart.
You’re not going to change overnight
If you borrowing money from your 401k, you’ve got to pay it back — generally within five years — and you’ve got to make substantially level payments on the loan at least quarterly. So let’s say you borrow $10K to pay off a credit card, and you’ve got 5 years to repay it. That means you’ve got to come up with $500 + interest every 3 months in order to pay the loan off on time.
By being in credit card debt, you’ve already proven that you have trouble planning for upcoming expenditures. Especially irregular ones. You’re not going to magically change overnight just because you now owe your 401k instead of VISA. Instead, you’re going to feel proud of yourself for “paying off” your credit card (even though all you really did was move it around.) And just like with debt consolidation, you’re likely to end up even deeper in debt.
If you want to pay off debt, stop borrowing money. Including from yourself.
You’ll be in trouble if you lose your job
Do you want to be locked into your job for the next 5 years? No? Well, you probably will be if you borrow from your 401k.
That’s because if you leave your job, the entire loan usually comes due immediately. And if you can’t repay it, it gets treated as a distribution. This is the case even if you leave your job involuntarily — such as if you get laid off or fired.
That’s bad, because distributions are subject to a 10% tax rate PLUS your normal tax rate — which may then be abnormally high if your distribution kicks you into the next tax bracket.
Suppose you borrowed $10,000, your normal taxable income is $32,000, and your normal federal taxes are $4375. Then you lose your job now, and are lucky enough to quickly find another one making the same amount of money. If you aren’t able to comply with the rules about repaying that distribution, your taxable income would shoot to $42,000. That’d make your federal taxes + penalty $7625. So you’d have to come up with an extra $3250, which I’m guessing you wouldn’t have if you were borrowing from your 401k. I don’t know about you, but I have zero desire to owe the IRS money.
Yeah, I know, you don’t think it will happen to you. But it can. And then not only will you owe even more money than you owed to begin with, you’ll have lost money that could have made an enormous difference in retirement. Ignoring risks and failing to plan for the worse are actions that cause debt in the first place.
If you want to get out of debt…
Don’t go for the “easy” way. That usually turns out to be the hardest way. Instead, change your habits. Stop borrowing money. Start using the debt snowball method. Yes, it’s frustrating to have to wait to get your debts paid off, and to have to work for it.
But it’s also awesome, because taking the time to make a permanent change like that improves your life for the better in so many ways. It’s worth it. And it usually ends up being faster, too.