Youll Lose Access To Financial Hardship Programs
When you use a 401 loan to pay off student loan debt, you also give up access to financial hardship programs.
These are typically available with federal student loans.
These programs help graduates who cannot afford their monthly student loans payments.
Theyll either receive a lower payment, or theyre allowed to stop making their loan payments temporarily without penalty.
If you get a 401 loan and cant repay this loan, there are no hardship provisions available to help you.
The upside is that defaulting on a 401 loan doesnt damage your credit score. Even so, failure to repay any remaining loan balance is considered a withdrawal. Youre then subject to taxes and penalties.
Addressing The Math And The Psychology Of 401 Loans
A reader sent me an email recently seeking advice on paying off a private consolidation loan with a 401 loan. The 401 loan would cut his payments from $350 per month to $150, with a significantly lower interest rate. Great, right?
On the contrary. There’s a lot of math and psychology involved in a decision like this. Here’s my take on it.
The mathThis reader, let’s call him Bond, is carrying about $8,000 on the consolidation loan, which has a 16.5% interest rate. The 401 loan has a 4.5% interest rate. That’s a significant difference, but don’t be fooled. Let’s compare the payoff period for these two loans:
As is, the consolidation loan will be paid off in a little over two years, with a total interest charge of $1,670. On the other hand, the 401 loan will take five years to pay. Bond will save about $700 on interest, but he’ll also be paying off the loan for five years instead of two.
Psychologically and from a risk standpoint, this is a huge difference. Most 401 loans are generous with repayment while you remain employed by your company. However, if you decide to leave your job, or are involuntarily removed from it, the loan almost always becomes payable in full right away. Some people stay in the same job for years on end and have almost total employment security — many people don’t.
Another optionProvided the 401 loan is pre-payable, there is of course a third option: take the loan, and pay it as though paying the consolidation loan.
Youre Executing A Bad Financial Game Plan
Taking money out of your 401 is like throwing a Hail Mary passits a last-ditch attempt to solve a desperate problem. Thats not how champions play! They win by consistently executing a proven game plan over time that sets them up for victory.
The only time you should withdraw money from or cash out your 401 is to avoid bankruptcy or foreclosureand thats only if youve exhausted all other options, like taking on extra jobs and a short sale on your house.
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Disadvantages Of 401 Loans
- Opportunity CostThe money you borrow will not benefit from the potentially higher returns of your 401 investments. Additionally, many people who take loans also stop contributing. This means the further loss of potential earnings and any matching contributions.
- Risk of Job LossA 401 loan not paid is deemed a distribution, subject to income taxes and a 10% penalty tax if you are under age 59½. Should you switch jobs or get laid off, your 401 loan becomes immediately due. If you do not have the cash to pay the balance, it will have tax consequences.
- Red Flag AlertBorrowing from retirement savings to fund current expenditures could be a red flag. It may be a sign of overspending. You may save money by paying off your high-interest credit-card balances, but if these balances get run up again, you may have done yourself more harm.
Most financial experts caution against borrowing from your 401, but they also concede that a loan may be a more appropriate alternative to an outright distribution, if the funds are absolutely needed.
1. NerdWallet, 2020 American Household Credit Card Debt Study2. Distributions from 401 plans and most other employer-sponsored retirement plans are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. Generally, once you reach age 72, you must begin taking required minimum distributions.
Should You Use Your 401 Money To Pay Off Debt
November 20, 2012 by National Debt Relief
I read an article recently where a woman was asking if she should take money out of her 401 to pay off $15,000 in credit card debt so she could use the money to pay off her mortgage next year.
Maybe not a good idea
In this womans case, taking money out of a 401 to pay off her credit card debt was probably not a good idea because she will be 61 in December of this year. This means she would not have to pay a penalty on the withdrawal but would have to pay taxes on it. While 20% would be automatically withheld from the distribution, her tax bill could still be higher depending on her state and federal tax brackets. For example, if she were in the 25% federal and 8% stake tax brackets, she would owe $3,750 to the feds and $1,200 in state taxes on that $15,000 withdrawal. This means that even without having to pay any penalties, she would still lose one third of her withdrawal to taxes. Plus, any money she took out would not earn any future tax-deferred returns for her.
Borrowing money from a 401
If you dont have a 401
The pros and cons
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Increase Your Investment Return
There are certain situations where you can use a 401 loan to increase your overall investment return. Heres a hypothetical example showing how it can work.
Lets say that the following things are true:
- Your 401 money is invested partially in a stock mutual fund and partially in a bond mutual fund.
- The bond mutual fund currently has an SEC Yield of 1.97%, meaning you can expect about a 1.97% return from that fund going forward .
- You can borrow money from your 401 at 4.5%.
Given that scenario, here are the steps you could take to increase your expected investment return while only adding a small amount of risk:
In other words, youre getting essentially the same return on your bond fund in the taxable account, minus the tax cost. But you get a higher return in your 401 because the interest rate is higher than the expected return on the bond fund.
Here are a few things to keep in mind as you consider this approach:
Why You Shouldnt Use 401k Loans To Pay Off Credit Cards:
There are plenty of better alternatives to getting a 401k loan to pay off credit cards. For instance, consider moving your current credit card balance to a 0% balance transfer credit card or getting a personal loan for credit card consolidation.
A balance transfer credit card can give you anywhere from 6 to 21 months to pay off your balance interest-free, after which point any remaining balance accrues interest at the cards high regular APR. If you have the good or excellent credit usually necessary to get such a card and think you can pay off the entire balance during the 0% period, that could be the best option for you.
A personal loan is a better option if you wont be able to pay off your credit cards quickly. If you have excellent credit, you could potentially get APRs as low as 4% to 6%, which is extremely cheap compared to even the best credit card APRs. If you have good credit, you might not be able to get the absolute lowest rates, but you should still get a fairly cheap APR considering most personal loans have credit score requirements 40+ points below the start of the good credit range.
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How Long Do You Have To Repay A 401 Loan
Generally, you have up to five years to repay a 401 loan, although the term may be longer if youre using the money to buy your principal residence. IRS guidance says that loans should be repaid in substantially equal payments that include principal and interest and that are paid at least quarterly. Your plan may also allow you to repay your loan through payroll deductions.
The CARES Act allows plan sponsors to provide qualified borrowers with up to an additional year to pay off their 401 loans.
The interest rate youll pay on the loan is typically determined by the plan administrator based on the current prime rate, but it and the repayment schedule should be similar to what you might expect to receive from a bank loan. Also, the interest isnt paid to a lender since youre borrowing your own money, the interest you pay is added to your own 401 account.
What You Should Do Instead To Pay Off Your Credit Card Debt
In hindsight, Nitzsche says he would have handled his credit card debt differently, such as reaching out to the specific issuers to inquire about a financial hardship plan or participating in a debt management plan through a credit counselor.
He also recommends using balance transfer credit cards, which allow qualifying cardholders to move their credit card balances from one card to the next.
If you have credit card debt, this could be a good option as long as you have a plan to pay off the transferred balance within the card’s introductory no-interest period , otherwise you accrue more interest on top of that debt.
The Citi Simplicity® Card that offers 0% APR for the first 12 months on new purchases and 21 months for balance transfers . To qualify for these longer interest-free periods, you will most likely need to have good or excellent credit, but there are options available for fair credit as well.
The Aspire Platinum Mastercard® is one where applicants with fair or good credit may qualify, but the balance transfer period is shorter at only six months. After the intro period, there’s a relatively low variable APR of 9.65% to 18.00%.
Note that depending on your credit, you may not get approved for a credit limit high enough to cover the full balance of your debt. And while there are some balance transfer cards with no fee, most usually require a 2% to 5% fee .
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When Should I Borrow Money To Pay Off Debt
Borrowing money to pay off other debt can be a slippery slope. Essentially, you are creating debt to eliminate another form of debt. This can work well to save money and reduce your overall debt when done correctly.
However, it can also create other issues and more debt if you are not careful. Cashing out your retirement account to pay off your house is probably not a great idea. This reduces your retirement nest egg and limits the amount of investment growth.
Borrowing money to pay off debt all comes down to the interest rates on both sides. It works best to borrow money at a low interest rate and use it to pay off a higher rate.
Credit card debt is a great example of this. Often times, they can have interest rates in the 20% to 30% range. If you can get a loan for 5%, you will significantly cut the amount of interest you have to repay. This helps to get out of debt faster and reach financial freedom.
Are 401 Withdrawals Subject To Taxes And Penalties
Even if you can qualify for a hardship distribution, its a good idea to plan to pay taxes on the distribution . And, unless you meet specific criteria to qualify for a waiver , youll also pay a 10% early withdrawal penalty if youre younger than 59½.
So, lets say youre 33 years old, and you have enough in your 401 to withdraw the $20,000 you need. Right off the top, unless you qualify for a waiver, you can expect to pay a $2,000 early withdrawal penalty. Then, when you file your income tax return, that 401 distribution will most likely be counted as ordinary income, so it will cost you even more. And if that added income bumps you into another tax bracket, you could end up paying even more.
But taxes and penalties arent the only costs to consider when youre deciding whether to go the distribution route.
Since compound interest creates the potential for your initial investment to grow significantly over time, every dollar you take out now could mean several dollars less in retirement. Essentially, withdrawing from your 401 now is like borrowing money from your future self, because youre losing long-term growth.
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You Have Bad Credit And Cannot Qualify For Refinancing
Student loan consolidation or refinancing can help you get a lower interest rate and a lower monthly payment.
But qualifying for refinancing will likely require a credit check, and you may not qualify with a low credit score.
If you cant qualify but desperately need a lower payment, using a 401 loan to off your student debt might be the solution.
Chances are, youll get a lower rate on your 401 loan.
And because a 401 loan doesnt involve a credit check, you dont have to worry about bad credit disqualifying you.
Tax Penalty For Taking Money Out Of Your Roth 401k Early
Since you paid initial taxes on your Roth 401k contributions, you may take your contributions back out without paying a penalty. In other words, if you invested $25,000 and your investment has grown to $50,000, you may take up to $25,000 out of your Roth without paying an early withdrawal penalty.
In contrast, if you took $30,000 out of your account, you would pay a 10% penalty on the $5,000 because that was an investment gain and more than your $25,000 contribution. However, before you run out and take your contributions out, keep reading to see the devastating impact taking your money out of your investments early can have on your retirement savings.
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Borrowing From Your 401
- No Credit CheckIf you have trouble getting credit, borrowing from a 401 requires no credit check so as long as your 401 permits loans, you should be able to borrow.
- More ConvenientBorrowing from your 401 usually requires less paperwork and is quicker than the alternative.
- Competitive Interest RatesWhile the rate you pay depends upon the terms your 401 sets out, the rate is typically lower than the rate you will pay on personal loans or through a credit card. Plus, the interest you pay will be to yourself rather than to a finance company.
Cons Of Using 401 To Pay Off Debt
When the stock market is consistently rising its known as a bull market. That means the funds in your 401 plan are increasing in value. Taking them out while that is happening could cost you those potential gains. This is the most common argument against 401 loans, but it only affects you when the market is bullish. Other legitimate cons include the following:
- Risk of Job Loss: As we all learned in 2020, no job is guaranteed to be secure. If you lose your job while you still owe money on a 401 loan, the IRS requires you to pay off the remaining balance within sixty days. Failing to do that will reclassify the loan as an early withdrawal and youll be subject to a 10% fee and income taxes.
- The S& P 500 is Up 20% This Year: The timing for a 401 loan should be carefully considered. The S& P 500 is up 20% this year, so taking funds from your retirement account is probably not the best option. A personal loan, despite the higher interest rate, would be more cost-effective.
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Option 2 Using The 401k To Pay Off Debt
a. Stock market goes up 10%.
1. You earn $0.00 on your investment.
2. You lose $0.00 on the interest you paid to your credit cards.
3. Total loss is $0.00.
b. Stock market goes down 10%.
1. You lose $0.00 on your investment.
2. You lose $0.00 on the interest you paid to your credit cards.
3. Total loss is $0.00.
Now looking at those numbers, I would say borrowing is the least expensive way to go unless the stock market gains more than 18%. Keep in mind that the opportunity cost of not borrowing the money means that you are still paying 18% interest. So when evaluating whether or not to borrow money, the odds are that your 401k is not going to return 18% plus gains year over year and the numbers are saying to borrow if you have already explored and exhausted other potential options.