Why Borrowing from a Retirement Plan to Pay off Debt is a Bad Idea
It sounds like a no brainer: you’ve racked up high-interest credit card debt, so to pay it off, you plan to borrow from your 401(k)/403(b) plan at a low interest rate that you (in most cases) pay back to yourself. Thus replacing high-interest debt with loan interest debt - and saving tons of money in the process.
While it appears to be a savvy financial move - here’s why it is may not be:
- Borrowing more doesn’t address the issue of how the debt was acquired in the first place. — If you have a large amount of debt, it was likely caused by a variety of factors, including failing to track spending and failing to budget. Those problems don’t go away when you borrow even more! If the fundamental issues are not addressed, the debt can quickly come back. In fact, the world is littered with people who took out 401(k)/403(b) loans to pay off debt and still face the same level of debt - or worse.
- Some retirement plans require immediate repayment of loans if you change jobs, or else the entire loan is offset against your retirement plan account balance. — In most 401(k) plans (and some 403(b) plans) you cannot continue your loan repayment if you terminate your employment with the sponsoring employer. Instead, if you change jobs or leave your employer, the entire outstanding loan balance is offset from your retirement plan account, reducing your retirement savings. Now, you can make up for this lost savings by coming up with an amount equal to the outstanding loan and rolling it over to an IRA or other qualified plan prior to the filing deadline of your tax return for the year of the offset (this is one of the perks of the tax reform bill that was passed in 2018), but if you had that type of money lying around, you probably would not have taken a loan in the first place.
- Even if you don’t change jobs, you are sacrificing retirement income. — As was brilliantly stated in the Arrest Your Debt blog, “Do not rob your future self to pay the debts of your present self.” And borrowing from a retirement plan will ultimately reduce your income in retirement. The earlier in your working career you borrow, the greater the impact; due to the time-value of money. Not only does the loan principal impact your retirement income, but the interest you pay back to your account is far less than the money you would have earned on your loan amount had you left it in the retirement plan, so you lose those funds as well. Finally, you pay that interest back to your account on an after-tax basis. This means that you are taxed twice on that interest, once when you pulled it from income that was already taxed to make loan repayments, and again when that interest is ultimately withdrawn from your retirement plan (note that loan principal is not taxed twice, since you received that principal from your account tax-free, which is offset when you repay that tax-free loan with after-tax income).
So, before you take that “no-brainer” retirement plan loan to pay off your debt, explore some alternatives like contacting your credit card company to negotiate a more favorable interest rate, start tracking your spending, and set a budget (some additional methods can be found in the Arrest Your Debt blog, mentioned above). And for the plan sponsors out there, adding debt management, student loan repayment assistance, financial education services, and automated emergency savings vehicles to your employee benefits array can help prevent loan over-utilization in your retirement plan, a problem that can increase recordkeeping fees not only for those who borrow, but for those who don’t!
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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