Using 401K Loan to Pay Off Debt: 5 Rules You Have to Know
Updated: Aug 18, 2020
If you are considering paying off your debt with your 401K, you are not alone. Many 401K plans already have a system in place where users can borrow against their 401K retirement savings. These 401K loans after have low interest rates because they are backed by collateral, your retirement account.
But you should also keep in mind that you are potentially risking your retirement, so it’s not a decision that should be made lightly. We have highlighted some of the most common loan rules that you must abide by when borrowing from your 401K, as well as some of the pros and cons, best practices, and common questions people usually have about this process.
401K Loans Rules
Before you make the decision to use your 401K, you’ll have to figure out whether or not you are eligible to withdraw the funds early. Depending on your employer, or the type of 401K plan you have, the rules for your 401K may look different than others. it’s common to see the allowance of borrowing up to half of your retirement balance for a maximum of up to five years.
A typical limit is around $50,000, but again yours could look different based on your current debts and income. If whatever is 50% of your account balance is less than around $10,000, some plans will let you borrow up to $10,000.
Because of the Coronavirus/Covid19 pandemic, Congress has passed the 2020 CARES act which may qualify you to borrow up to $100,000 for various hardship relief.
Those thinking on using their 401K plan as collateral for a loan must usually meet all or some of the following requirements:
Your 401K is your collateral, so the amount you can borrow will be a fraction of your plan’s value.
Your loan must be within the permitted lending limits, and cannot exceed the maximum amount permitted. (You can’t borrow $45,000 against a 401K that’s only worth $35,000)
Each and every loan must be established under a binding written loan agreement, from a licensed or certified loan officer or lending establishment.
Unless you are using your loan for the purchase of a principal residence, it must be paid back within a term of five years.
When making payments back to your loan, they must be done so quarterly at the minimum and in substantially equal payments that include interest and principal.
Business owners and HR managers do have some flexibility when designing a loan program around the company’s 401K policies. So exact rules may vary depending on your employer and the specifics of your 401K plan.
Cashing Out 401K To Pay Off Debt
In addition to taking out a loan against your 401K to pay off debt, you also have the option of withdrawing the actual funds from your 401K. This is not recommended unless it’s an emergency. Your 401K depends on longevity and compound interest to truly be successful, if you withdraw funds early you can be costing yourself exponential earnings later on down the line as you ease towards retirement.
Whether or not you decide to access your 401K early to pay off loans, it may already be decided for you if you simply do not qualify. In most scenarios, you can only withdraw the deposits you made into your retirement fund (or elective-deferral contributions) and not what your employer has deposited.
According to the IRS, all of the money your employer deposits into your 401K is completely ineligible to take out for debt repayment. You cannot access these funds because your employer contributed the money on the sole benefactor of your retirement and nothing else.
The IRS has very strict rules for retirement accounts, these rules are what makes loans against your 401K an easier option.
However, there is one exception. If you have been laid off, you may be able to access and withdraw your early retirement money. This is all dependent on the conditions of the plan you initially signed up for.
Some plans will not allow you to access your 401K entirely until you retire, and some will only let you withdraw it for hardship situations only. These can include tuition or education fees, significant medical expenses, or to prevent foreclosure and eviction.
For people looking to use their 401K for necessary home repairs, look into a small loan for your home repair, because in some situations debt can be considered an eligible hardship case if it’s allowed by your plan. Additionally, the specific types of repairs needed on your home may qualify for hardship guidelines. Ex: If a storm tore a chunk of your roof off.
Pros and Cons Of Getting A 401K Loan To Pay Off Debt
Out of all Americans that have any type of game plan for retirement, 1 in 4 have got a 401K (only private sector counted). Many Americans are also into debt, most commonly in the form of high-interest credit card debt. Should you take out a loan against your 401K to pay that debt? Let’s take a look at the pros and cons.
Pros Of Using A 401K Loan To Pay Off Debt:
● Because your 401K acts as collateral, the loans have got great interest rates.
● The interest rates change with the economy. Usually 1% above WSJ prime, if you need money because the economy is in a slump, you will benefit from the lower rate.
● Interest paid is to your own 401K account.
● Your credit score will not be immediately or directly impacted.
Cons Of Using A 401K Loan To Pay Off Debt:
● Your retirement savings will be significantly derailed. Compound interest takes time to work in your favor. A 5 year loan for $10,000 can end up costing you nearly $18,000 in the long run, depending on swings in the economy.
Even after the $10,000 has been paid back, you will still have missed out on a potential $18,000 depending on what the remaining 401K balance is.
● You will likely incur tax-related penalties and fines. (which we have outlined below)
● Depending on your debt (such as high-interest credit card debt), Chapter 7 bankruptcy may be better than using your 401K. Credit card debt can easily be discharged, a 401K loan cannot.
● Simply taking out a 401K loan to pay off debt doesn’t attack the root cause of the actual debt. It’s possible you may get in over your head again with your original debt AND now your 401K loan on top of that.
Early 401K Withdrawal Penalties And Taxes
When you decide to withdraw from your retirement earlier than expected, you will have to pay your ordinary income taxes as well as a 10% tax penalty, or what will be considered an early withdrawal penalty.
But also, since you were not taxed on your 401K contribution, you will now also have to pay federal income tax on your loan withdrawal. Of course, if you didn’t deposit the money directly into your 401K, you would have ended up paying taxes on it anyways. The only difference is you wouldn’t have faced that one year period where you'd have to pay all of your taxes back at once, and it would have been a lower tax rate.
I know we keep repeating this, but you need to understand how important it is: any money you borrow from your retirement misses out on both compound interest and market gains. More often than not people reduce their 401K contributions and end up with a smaller nest egg once they reach retirement.
The cons we mentioned are not meant to scare you, in fact there are good reasons to use your 401K to pay off your debt. Especially if all other options have been exhausted and you need to pay off your high-interest debt, and the interest rate on a 401K plan is less, then a one time loan might make the most financial sense.
Do 401k Loans Affect Mortgage Applications?
We mentioned above that a 401K loan will not directly affect your credit score. It will also have no effect on a mortgage application. Whenever creditors consider you for a loan, they do more than look at your credit score.
They look at your DTI, or Debt to Income ratio. It’s a ratio of how much money you bring home every month versus how much goes out to monthly obligations. A loan against your 401K is not actually considered a debt. Because of this, it will not count for or against your debt to income ratio.
In fact, you can buy a home with your 401K. Current guidelines state that as long as it’s for a primary residence, it can be used to buy a home. You will also be eligible for longer repayment terms outside of the 5 year maximum.
Additionally, because of the 2020 CARES act, you may be eligible to borrow up to $100,000, far surpassing the $50,000 maximum that is currently in place.
Final Thoughts On Paying Debt With A 401K Loan
As we have mentioned numerous times now, a loan against your 401K can make you miss out on compound interest and market gains. There is a problem with this logic that is wholly dependent on the economy.
If you need money so desperately that you would borrow from your 401K, it’s possible the economy is in bad shape. If the economy is in bad shape then that means you probably weren’t going to realize good market gains anyways.
The important thing is to do your research, understand the process, consider alternatives, and if you do end up using your 401K to pay off debt, make sure the debt you’re paying off has a higher interest rate than that of your 401K loan, and make sure it gets paid back quickly.
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