Is Borrowing from Your 401(k) for Debt Consolidation the Right Choice?

Tapping your 401(k) account to consolidate debt appears to offers a great deal of advantages over other options; however, its fair share of drawbacks makes this option less appealing. Most 401(k) plans allow participants to borrow up to 50% of the vested balance or $50,000, whichever is less. You then have up to 5 years to repay the balance of the loan as long as you remain with the same employer.

Advantages to using your 401(k) for debt consolidation:

• No credit check or qualification guidelines--Regardless of your credit score or financial situation, you will be approved for the loan.
• Low interest rate--The interest rate associated with the loan will be set by the individual plan. However, typically it will be the prime rate plus a couple of percentage points. This is probably much lower than the interest rates you are paying on an unsecured consumer debt.
• Quick and convenient--The process of acquiring the loan from your 401(k) can often be as simple as a phone call or filling out a short form.
• You receive the interest--The interest you pay as part of the loan goes back to you. It acts like a forced savings account.

Disadvantages to using your 401(k) for debt consolidation:

• Must stay employed--If you quit or lose your job, you will need to repay the full balance of the loan within 2-3 months (depending on the plan) or face owing income taxes plus a 10% penalty on the balance if you are under the age of 59 ¹/₂.
• No tax deduction--The interest you repay as part of the loan is not tax deductible like a mortgage or home equity loan. It is treated like any other consumer loan.
• After tax dollars-When repaying the loan, you are using after-tax dollars and will then pay taxes again once you begin taking withdrawals in retirement. This negates the tax-deferred benefit of a 401(k).
• Miss out on interest and earnings--Once you have borrowed money from your 401(k), that money is no longer earning interest and you miss out on the benefits of tax-deferred compounding interest. For example, if you borrowed $35,000 at the age of 30 and repay the loan over 5 years, when you reach the age of 59¹/₂., you may have earned $129,553 less than you would have had you not borrowed the money. This assumes you were repaying the loan at an interest rate of 6%, earning an annualized rate of return of 8%, and did not make any additional contributions during the repayment of the loan.

Bottom-line regarding using a 401(k) for debt consolidation:
The tax consequences and potential investment losses that come from accessing your 401(k) for a debt consolidation loan make it one of the last options you should consider. First, explore converting any non-retirement assets, borrowing against the equity in your home, consider selling some of your personal possessions in an effort to raise money to pay down your debt and always consult a debt expert.

Source:
National Center for Policy Analysis

About the Author:
Chris Rocks is the Founder and Executive Director of the Credit Advisory Alliance (CAA). CAA is a nationwide membership-based organization that assists consumers recovering from a financial difficulty and those who need a significant increase in their credit score.

Chris began his financial services career as a Financial Advisor helping young families with risk management and asset accumulation strategies. It was during that time that Chris realized that many of these young families also needed someone to guide their choices with regards to debt management.

He made the transition into the mortgage industry where he first worked as a loan originator and later the Vice President of a small mortgage company. As Chris came across clients who had suffered through financial challenges and saw the difficulty they had in re-entering our credit driven economy, he discovered there was a real opportunity to leverage his unique background and help others.