Budgeting Conundrum: What Are the Benefits of a 401(k) Loan to Pay Off Debt?

Your 401(k) plan is designed to help you save for your retirement. Anytime you take money out of the account, you're depleting your long-term savings. To discourage you from accessing the funds early, the Internal Revenue Service taxes and penalizes withdrawals before retirement age. However, if you have a short-term emergency need for funds, you may be able to avoid these costs by taking a 401(k) loan. Properly done, a 401(k) loan avoids all penalties and taxes. If you use the loan proceeds to pay off debt, and you're able to repay the loan on schedule, you might actually save money over the long run.

A 401(k) loan might be an option for you to get out of debt.

Lower Interest Rate on 401(k) Loan

When determining the value in taking a 401(k) loan to pay off debt, compare the interest rates. Jeff Gonzalez, a Los Angeles-based certified public accountant, says, "The interest rate on credit cards is typically higher than you'd have to pay on a 401(k) loan." Both rates are typically based on the prime rate. However, 401(k) loan rates are usually only a percentage point or two above the prime rate, while credit cards can be 10 percent or more above the prime rate. If you can take out a 401(k) loan at 5 percent, and your credit card interest rate is 15 percent, you'd save 10 percent per year in interest. Other interest rates, such as those on personal loans, may be lower than credit card interest, but still will often be higher than 401(k) loan rates.

Pay Interest to Yourself

When you take out a 401(k) loan, you have to make regular payments, just like any other type of loan. However, since you're essentially borrowing from yourself, you pay the interest on the loan back to yourself. Typically, your employer will take money out of your paycheck monthly to redeposit into your 401(k) plan. Those payments will consist of both interest and principal. "Psychologically, this can make a 401(k) loan attractive to many borrowers," Gonzalez says, "since paying money to yourself generally feels better than shipping it off to a third-party creditor." Plus, paying interest to your account can help offset any gains you may have missed out on while the loan money was not in your 401(k), growing in value.

No Negative Credit Effects

When you apply for a credit card or other type of loan, the new credit application will show up on your credit report. This will typically drop your score by five or 10 points. However, a 401(k) loan has no effect on your credit report. This is because a 401(k) loan isn't technically a "loan," in the sense that a lender is extending you credit. Rather, you're being granted permission to access a portion of your balance without suffering taxes or penalties. If you use your 401(k) loan to pay down your debt, you might actually see a jump in your credit score, since your 401(k) loan isn't considered "debt" by the credit scoring agencies.

Limitations on Borrowing From Your 401(k)

A 401(k) loan may have drawbacks and limitations, depending on your circumstances. Not all employers offer 401(k) loans, even though the IRS permits them. Some plans may have more restrictive terms than others. The most you can borrow from your 401(k) plan is 50 percent of your vested account balance or $50,000, whichever is less.

You'll have to repay the loan within five years by IRS rules, and possibly sooner depending on your employer. If you do not repay your loan, the unpaid portion will be considered a distribution. If you're under age 59 1/2, you would have to pay ordinary income tax on the distribution and would usually be liable for a 10 percent penalty, too.

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