Many Americans are having a hard time making mortgage or credit card payments, and every day we talk to people who are thinking about borrowing against their retirement accounts to pay off their debt. While it may be tempting to pay off your credit card debt by borrowing against your 401k, you may want to reconsider that strategy.
Not only will it reduce the money you need for your retirement, it will reduce your long-term performance, there will be taxes and interest. Virtually all plans will allow you to borrow the money for a point or two above the prime rate. The most you can borrow is usually less than half of the account, or $50,000, whichever is less. You’ll have to repay that money within fifteen years if you used it for a mortgage, and five years for anything else. They also charge fees to do this of a hundred dollars or so. If something happens and you can’t pay it back within these times, and you’re under 59 ½, you’ll have to pay income tax on the amount, plus a 10% early withdrawal penalty.
Even with these potential future fees, many people are maxed out on their credit cards and can’t access the remaining equity in their homes as credit tightens and people aren’t getting home equity loans like they were before the bubble burst. . Without an approval process for a 401(k) loan, there are no requirements or reasons to be turned down. It’s your money, and it’s there if you really need to borrow it.
It’s also increasing the number of “hardship” withdrawals the IRS allows for funerals, medical bills, avoiding eviction or buying a first home. Since people can no longer get creative with principal withdrawals from their home equity, they are getting creative with other ways to access equity to keep bills paid; however, the 401(k) should be the loan of last resort. The Principal financial group reports that in August 2007, requests to withdraw money to avoid foreclosure doubled from July. Clearly this is another bubble that could burst in the future.
Even if you can repay the loan before there are penalties, you are taxed twice on the loan, once when you pay the loan off with after-tax dollars and again when you withdraw your retirement money. Do you really want to be paying taxes on taxes? Also, you are cheating your future because that money will not be invested or grow. If you borrowed $10,000 when you’re forty, against a $150,000 401(k), you’ll see a decrease of more than $83,000 when you withdraw at age 65 versus $100,000. if you left the money alone. That should be enough to discourage you from doing this unless you absolutely have to.
And you better have job security, because if you get fired, quit, or fired, you’ll have to pay off the loan within 90 days, and if you’re under 59 ½, you’ll get those penalties and income tax. That extra income you borrow could also move you into the next higher tax bracket, costing you even more in taxes.
Unless you’re that desperate, it’s your last resort, it sounds like borrowing against your 401(k) to pay off your debt isn’t a good idea.