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Dear Penny: Should I take a 401(k) loan to pay off $10K of debt?

Another risk of taking a loan from your retirement account comes if you leave your job for some reason.
 
If you have good credit, you could look into whether a debt consolidation loan could lower your interest rates.
If you have good credit, you could look into whether a debt consolidation loan could lower your interest rates. [ VADYM PASTUKH | Getty Images/iStockphoto ]
Published July 7, 2023|Updated July 7, 2023

Dear Penny,

I’m 61 years old and still working full time. My job allows loans on our retirement plan. I have just over $120,000 between my retirement and pension. Not nearly enough to retire on, obviously.

Would it make sense to pay off all my debt of $10,000 from my retirement? It would consolidate everything into one. The interest rate is about 5%. Basically, I’d be paying myself back. So by the time I’m ready to retire in about five years, it’ll be paid off, if not before.

— S.

Robin Hartill
Robin Hartill [ The Penny Hoarder ]

Dear S.,

I certainly get why a loan from your retirement plan looks tempting here. You’d get to eliminate your consumer debt in one swoop. Not only would you most likely lower your interest payments at a time when rates are high, but you’d also be paying interest to yourself. Plus, unlike with a 401(k) withdrawal, you don’t pay taxes on a loan. Most plans allow you to borrow up to 50% of your vested balance, up to a $50,000 maximum.

But I’d still avoid the retirement plan loan for a couple of reasons, unless you have no other options for paying that $10,000 of debt.

You acknowledge that you don’t have enough saved for retirement. The issue isn’t just about how much you’re paying in interest, but also the returns you’re giving up. You need to keep the money you currently have saved invested and growing for as long as possible.

Plus, plans typically don’t allow you to contribute while you have an outstanding loan, so you’d set back your retirement savings goal even further. That’s an especially big drawback if your employer matches part of your contributions. That’s free money you’ll be passing over for as long as the loan is outstanding.

Another risk of taking a loan from your retirement account comes if you leave your job for some reason. Many plans require full repayment of a 401(k) loan if you quit your job or get fired, in which case the full $10,000 could be treated as a distribution and taxed as ordinary income. (For people 59½ and younger, a 10% early withdrawal penalty would also apply.) Even if your plan doesn’t require immediate repayment, the IRS would require you to repay it in full by Tax Day. So if you left your job on Dec. 31, 2023, you’d have until April 15, 2024, to pay it back.

If you have good credit, you could look into whether a debt consolidation loan could lower your interest rates. Doing so would lump everything into one loan, as you desire.

Otherwise, you might consider paying off your balances using the debt snowball method. Essentially, you make the minimum payment on each debt, then put every extra dollar toward tackling the smallest balance. Once that debt is paid off, you repeat the process and put your excess funds toward the next-smallest balance until you’re debt-free. This approach tends to be successful because every balance you tackle feels like a win.

If you’re determined to borrow from your 401(k), though, make sure you talk to your plan’s administrator so you understand the repayment rules that would apply if you unexpectedly lost your job. You should also have a plan to repay the loan as quickly as possible. Make sure you’re putting both the full amount you’re paying on your debt and putting into your 401(k) toward the loan each month. That way, you can get back to contributing ASAP (and hopefully getting an employer match).

Fortunately, though, $10,000 is a relatively manageable amount of debt. I think you’ll be able to pay it off without tapping your 401(k).

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Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. Send your tricky money questions to AskPenny@thepennyhoarder.com.