Getting your debt payoff plan kicked off can take a while as you slowly chip away at your balances with what little money you have left over each month. If you have been doing some things right financially – like setting up automatic payments into your retirement account – you find yourself with some financial assets that you can use to pay off your balances.
You can withdraw funds from your retirement accounts to pay off debt, but this is normally a horrible idea. If you withdraw funds from a pre-tax retirement account like a 401k or Traditional IRA you will not only pay an early withdrawal fee of 10%, but you also have to pay income tax. Assuming you’re in the 25% tax bracket that means 35% of your withdrawal will disappear as taxes and fees. A withdrawal of $10,000 would only net you $6,500. That’s a horrible return of your funds and we haven’t even discussed the missed growth on those funds for your retirement.
Another option to consider if you have some money stashed away in retirement accounts is to get a loan of those funds that you will pay back. But is raiding your retirement accounts via a loan to pay off your debt a smart idea?
Borrowing From Your 401k or IRA
First, a clarification. Borrowing from your 401k is acceptable. Except in one very limited instance you cannot borrow from your IRA. (We’ll discuss this more in a moment.)
Taking money out of a retirement account to pay off a debt like a credit card is an unfortunate situation that shows you haven’t controlled your finances very well. At the same time, if this is a necessary step you need to make the corrections in your finances to avoid having to do it in the future. There’s no sense in saving for retirement if you have to keep borrowing the money over and over because you can’t stop spending money.
Borrowing From Your IRA
Under normal circumstances you cannot borrow from your IRA. However, there is a loophole that lets you take cash out for 60 days and then repay the exact same amount within 60 days. If you fail to return the money the withdrawal is considered a distribution which means you get hit with the taxes and fees mentioned above.
Positives of Borrowing From Your 401k
Again, having to borrow from your 401k isn’t a good thing, but at least there are some positives to making the move.
Paying Yourself Interest
The best part of borrowing money from your own retirement accounts is the interest you are paying goes back into your retirement account in addition to the principal portion of the payment.
Sure, you are paying interest. But it is going in your retirement account rather than to a credit card company, bank, credit union or personal loan organization. No one is profiting off of you taking out the loan because you’re getting all of the money back plus interest.
No Credit Check
Another huge perk of borrowing from yourself? You don’t have to pass a credit check. This is especially important if you have fallen behind on some debt and your credit score has tanked because of it. Any other type of loan whether credit card, personal loan, or home equity loan is going to require you to pay certain credit requirements (or at least charge you a higher interest rate if you have a terrible credit score).
Negatives of Borrowing From Your 401k
Putting your retirement funds at risk to pay off debt is a risky proposition. Here are some of the downsides.
Termination Makes Loan Due
The biggest risk of borrowing from a retirement accounted tied to your employment like a 401k is that if you are terminated for any reason (whether fired or laid off) the entire loan is due normally within 60 days. This makes this type of loan significantly more risky than other types because other loans can’t be called due that quickly.
Lost Investment Growth
A minor problem with borrowing from your retirement accounts is the money that you borrow won’t grow while you are using it to pay down debt elsewhere. This is more a minor problem than a major one because of a few factors: you are paying yourself interest which is like a set rate of growth, and there is no guarantee the market will go up while you borrow the funds. In fact if the market tanks and you pay the loan back with interest, you might see a slightly better return that you would have otherwise!
Pay Back with Post-Tax Funds
A bigger problem is that when you pay back your loan you are paying it back with money that has already been taxed, even if you’re borrowing from a pre-tax retirement account. So if you borrow $10,000 from yourself, you will pay back $10,000 (plus interest) from not your pre-tax funds but after you’ve already paid your tax rate on the money. So you might have to earn $13,333, pay 25% in taxes, and be left with $10,000 to pay the loan off.
Paying Off High Interest Debt
Borrowing money to pay off borrowed money is usually a losing proposition. Taking funds from your retirement account is only going to be worthwhile if you are paying off high interest rate debts like a credit card. If you can borrow from you retirement account at 10% to pay off a 20% credit card debt, you’re going to come out ahead because you are paying yourself the interest. Don’t borrow from yourself to pay off 3% debts; just pay off the debt on your own.
Borrowing your way out of debt is a difficult if not mathematically impossible scenario. However, compared to borrowing from a credit card, personal loan, or payday lender temporarily using some of your retirement funds to pay off high interest debt makes a lot of sense. No one else will profit from your loan and you pay yourself back the interest. Just make sure you make the important adjustments in your budget to avoid getting into significant amounts of debt in the future.