Following a recent financial planning webinar presentation, I was faced with a frequently asked question: Does it make sense to take out a 401(k) loan to consolidate debt?
This employee had definitely done her research on 401(k) loans, but she was wary after reading warnings from many financial planners and media gurus. However, this didn’t deter her from exploring a 401(k) loan as she was eager to eliminate her high interest credit cards and get them out of her life forever.
As a general rule, I always tell people that 401(k) loans should only be used as a last resort and there is more to consider than the interest rate and monthly payment. But it can be tempting and occasionally wise to use 401(k) loans to pay down debts, purchase a home, or pay for unexpected emergencies like medical expenses.
The pros of 401(k) loans
So, it’s important to realize the advantages and disadvantages as this decision can have a lasting impact on future retirement income.
The advantages are as follows:
- There is no credit check. The loan is from your retirement plan balance, making it easy to access your money without concerns about damaging your credit (or not qualifying for a loan based on bad credit).
- Interest rates are often lower than other personal loans available in the marketplace. Most 401(k) loans usually have low interest rates and are commonly linked to The Wall Street Journal prime rate (currently 3.25 percent). Compare this to the average credit card interest rate of around 15 percent and the savings can be significant. In addition, the interest you pay just goes back into your own account.
- You don’t have to pay taxes on loan proceeds. There are no taxes to pay since loans are not considered a taxable withdrawal. This is a more desirable alternative to hardship withdrawals, which are taxed at your ordinary income tax rates and often accompanied with an additional 10 percent penalty if you’re under age 59 ½.
The cons of 401(k) loans
Some of the disadvantages are as follows:
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- There is a potential risk that future earnings growth on investments will be lost. Opportunity cost is huge with 401(k) loans. Consider that many retirement plan loans have a 5 year term (some range up to 10-15 years) and investments in U.S. equities have historically been positive over rolling five year periods. Of course, it’s never wise to achieve future financial goals by looking in the rear view mirror and we have no idea what the future holds. The opportunity cost is also less of a concern when the loan amount is not a significant chunk of your entire retirement account or if you’re a conservative investor.
- Retirement plan loans are deducted directly out of your paycheck as an after-tax deduction. This will have an impact on your take-home pay and should be incorporated into your revised budget. Anytime there are changes to your paycheck you should review your personal spending plan to prepare for the change in pay ahead of time. You don’t want the loan payments to make it hard for you to pay your mortgage.
- You may potentially owe taxes and penalties if you leave your employer and default on the loan. This is perhaps the most significant risk of taking a 401(k) plan loan if you still owe money when you leave your job. In most cases, any amount that you don’t pay back within 60 days is considered a withdrawal and subject to taxes and possibly a 10 percent penalty if you’re under age 59 1/2. Even if you happen to work for an employer that does not require loan payoff if you’re laid off or leave before the loan is repaid, you still have to stay current with loan payments. This isn’t as simple to do without the ease of payroll deduction.
- If you don’t have the discipline to avoid future credit card use, you may end up with more debt. One of the biggest problems that I have witnessed with 401(k) loans is when they are used as a quick fix for a bigger money management or debt problem. I’ve worked with too many people whose credit card and consumer debt issues were compounded by a federal or state tax debt issue because they defaulted on a retirement plan loan. I’ve also seen too many people with good intentions use their retirement plan loans to consolidate debt and then succumb to the temptations to ramp up their credit card use, leaving them with more debt than when they took out the 401(k) loan.
Best Bet: Use a loan as a last resort
After reviewing the pros and cons of using a 401(k) loan to consolidate debt, there is no simple answer as to what the best option may be for each unique situation.
However, in general, I still stand by the guidance that retirement plan loans should only be used as a last resort. Even if the interest you are paying is still slightly higher than the 401(k) loan interest, there may be just too much at risk.
Retirement planning is hard enough these days and there are plenty of obstacles along the path to retirement. Taking out a retirement plan loan without doing your homework is risky and could be a major setback to your retirement plan.
This was originally published on the Financial Finesse blog for Workplace Financial Planning and Education.