Borrowing from the 401(k) plan to pay off debts: Is it worthy?


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401(K) is an employer-sponsored retirement plan that allows employees to save money for their retirement days in a tax-deferred manner. However, when the employee will retire and withdraw the money from the 401(K) plan, he/she needs to pay the tax on it.

How does the 401(k) plan work?

The 401(k) plan is managed by the employers. They decide the type of 401(k) workers can use and, what investments workers can select for their plan. Employers will also decide which investment management firm will run the investment part of the 401(k) plan. The employee has to sign up for the 401(K) plan from the first day of the job.

What are the benefits of contributing money to a 401(k) plan?

Employees can decide how much of their paycheck should be contributed to the 401(k) plan depending on the IRS contribution limit. They can also select investment vehicles while opening a 401(K) plan. The rest will be taken care of by the employer (plan sponsor).

Another benefit of contributing money to a 401(K) plan is that it allows users to take out a loan against their savings. Users can get relatively low-interest rate loans that they can use to consolidate their debts. So, it is clear that the 401(k) plan is one of the great ways to build wealth for your retirement days.

But today’s topic is not discussing the benefit of a 401 (K) plan in detail. Today’s topic is, should you take advantage of your 401(k) account to consolidate your debts?

Should you use a 401(K) loan to pay off your debts?

The answer cannot be said in one sentence. So, read the article to know the answer. As per the financial experts, taking out a 401(k) loan to pay off the debts should be your last resort. If you have another debt repayment option to get out of debt, then you shouldn’t borrow from your 401(k).

On the other hand, some financial experts say that borrowing money from a 401(k) plan is a less expensive option to repay the debts. If you’re drowning in multiple debts, then you can take advantage of a 401(K) plan.

Why you shouldn’t borrow from your 401(k) plan to pay off your debts

Though a large number of 401(K) users are taking advantage of their plan to get out of debts, the idea of borrowing money from the retirement plan is not good.

Here’s why you shouldn’t borrow from your 401(k) plan:

#You can’t save enough for your retirement

Remember, the major goal of having a 401(K) plan is to save enough money for when you will not be working anymore. In most 401(k) plans, there is a provision that prohibits the user from making additional contributions until the loan balance is repaid by you.

#You are not making a profit.

If you stop contributing money since you have an outstanding loan, the money is not growing. Also, you will miss the potential growth in the stock markets. The low interest that you are paying to yourself is very inadequate than the ROI that you can get from the market by contributing money thoroughly.

If you borrow a loan from it, then you should double your contribution to make most of it.

#You are losing time to grow your money

The more time you will give in a long-term investment like 401(K), the more wealth will build with time. As per the financial expert’s calculation, the money in 401(K) usually doubles on average every 8 years.

But if you take out a loan from the 401(K) plan, then you are losing the time to make up for the lost contribution. Since you are repaying the loan for a long period (usually 5 years). Therefore, you are losing growth opportunities.

#You may have to pay a withdrawal penalty.

If you are below 59 years, then you will be charged an early withdrawal penalty. Also, if you don’t repay the loan, you have to pay the tax on the outstanding balance. So, you could lose more money on your withdrawal.

#You can never retire.

If the user is unable to repay the loan 60 days of retirement, it will become fully taxable. Also, the user has to pay the 10% early withdrawal penalty. So, if you have a loan, you can’t quit your job without repaying the loan.

Why you should borrow from your 401(k) plan to pay off your debts

You can’t predict your financial life. You can face a financial challenge at any point in your life. Also, you may have to take out a loan from your 401(K) plan. Though you shouldn’t miss the opportunity to build wealth by taking out a loan from your retirement plan, here’s why you should borrow from your 401(k) plan.

Taking out a loan from a 401(k) plan to consolidate debts is beneficial because the debtor can get the loan with a relatively lower interest rate than the other commercial loans. When the debtors repay the loan, they are paying back to themselves the money with the interest instead of paying back to a financial institution or bank.

You can repay the loan from your paycheck. You can make the repayment automatically by setting up an automated system. So, no chance of missing the repayment on the new loan that you have borrowed from your 401(k) plan.

Usually, commercial loans have a higher interest rate and it takes a longer time to repay the loan. However, the 401(K) plan has a maximum 5-year term to repay the loan. You will be repaying the total balance sooner. If you borrow a loan from your 401(k) plan, it will not be reported to any credit bureaus. So your credit score will not get any negative effect from it.

Lastly, you shouldn’t invite financial difficulties by taking out a loan from your 401(K) plan when you are about to retire. It will not let you take full advantage of this plan. So, instead of making your retirement days insecure, you should find other ways to pay off your debts.