Back in August of 2012 I wrote a post about the Robin Hood principal of paying down your debt from borrowing and/or taking money from your retirement accounts to pay off your debts. I specifically stated “do use retirement monies to get out of debt”. However I was not surprised by the responses I received.
Back in August of last year while being interviewed, I was asked a similar question that I did not know the answer to right off the top of my head. That questions was; “Should I borrow from my retirement accounts, such as my 401(k), IRA or my wife’s 403(b) to pay off your debt?”
Not knowing the answer I did the research and wrote the following. I trust you will find this timely as timely today as when I originally wrote in back in 2012.
Today, approximately 85% of all employees with a retirement plan such as a 401(k) plan can borrow money from their plans for whatever purpose they desire. In addition, a growing number of 403(b) plan participants are now allowed to do the same thing. If you have been diligent about putting away a portion of your salary over the past few years and your employer has made some type of monetary match to your plan, there is a good chance that you have a fair amount of money socked away in one these accounts. That is barring the stock exchange fluctuations of the past few years.
Would it not be wise then to use this money to pay off my credit card debt especially if I utilize a debt reduction or a debt relief program? The question then becomes, “Does it make sense to take out a loan from your 401(k) or 403(b) for these reasons?” So I did some research.
I took a serious look at this, as many people think, sure, why not? In today’s environment, a typical 401(k) plan will allow you to borrow up to 50% of your vested balance, however not more than $50,000. Still other plans may limit this amount depending upon the purpose of the loan, such as for medical expenses, educational expenses or the purchase of a new home.
To begin with, this is a loan of money that you must pay back to your plan, along with interest, typically over a five year period. However, since you will be paying the interest to yourself, it is not an additional cost. You could think of it as a forced savings. However, if you elect to not pay the loan back, you will then owe the IRS income tax on that money, on top of a 10% early withdrawal penalty.
From that perspective, it does not make any sense to borrow money from a retirement plan to pay off debt this way. Why? There are three big negatives to borrowing from your 401(k) or 403(b) plans to pay off debt.
1.) You will be giving up the tax-free compounding of all monies that you withdraw.
2.) You will be replacing pretax money with after-tax money. Therefore, if you are in the say the 27% tax bracket, it will take $1.40 in salary to replace every $1 you withdrew from your account.
3.) Finally, if you leave your current employer, you will probably have to pay back the loan you borrowed from them immediately.
These three negatives far outweigh any positive to borrowing from your retirement plan to pay off your credit card debt. Instead, we suggest you make use of a debt reduction or debt relief company such as Nationwide Debt Reduction, Inc. to help you reduce your debt or pay off your credit cards for a fraction of what you currently owe rather than borrowing from your retirement plan. Or, you can call our toll free number at 800-890-6658 to speak with one of our trusted advisers.