Figuring out the balance between savings and debt is a financial exercise every American faces. Almost every employee has retirement in mind as a long-term goal. Most Americans take advantage of the employee opportunity to have a savings investment that is directly withdrawn from contributions from their paychecks. The most common plan known to Americans is the 401(k) Plan. In 2020, over 60 million active 401(k) members, both former employees and retirees, utilized over 600,000 different plans. With the large amount of money placed into 401(k) plans, some holders elect to use it to pay-off their debts. This article will address both the advantages and disadvantages of this financial strategy.
What are the Advantages to Using the 401(k) to Pay-off Debts?
Funds from a 401(k) Plan can address an immediate source of funds to help pay off debts. Some advantages include:
- Flexible Payment Timeframes – Taking out a loan against a 401(k) Plan provides some flexibility in the time needed to pay the loan back. For most 401(k) holders, a loan taken out has a repayment requirement of 5 years. Most holders will elect to pay the loan back on a monthly basis.
- Paycheck Convenience – Some 401(k) repayment plans allow for the convenience of repaying the loan through a direct deductible from an employee paycheck4. Similar to a direct deduction taken to pay into a 401(k), the direct payment allows for the convenience of never having to go to physically go to the bank and deposit any checks.
- Lower Interest Rate – When taking out a loan, the most important amount to monitor is the interest rate attached to the loan. Some 401(k) Plans offer loans with lower interest rates which makes the loan much more competitive than other traditional bank offerings5.
- Limited Contributions – Some 401(k) repayment plans allow for the holder to put a pause on their contributions while they are still paying off their debt. The flexibility ultimately will lead to a result of more “cash-in-hand”6.
- Quick and Easy Approval – Unlike some other loans that require approvals and collaterals, the convenience of a 401(k) is that there is a direct fund already that is being borrowed against. The ability to borrow against the fund can happen almost immediately without the hassle of having to prove an ability to pay back. Borrowed cash, in minor amounts, may be transferred to your debit card without interrupting your credit score. Furthermore, since you own your account, you do not need to apply for hassle requirements, and no credit score is required6.
- Tax Strategy Breaks – Some loan structures provide for some flexibility in tax payments. For example, as long as a debtor “pays” their withdrawal within the five-year period, most plans will allow the holder to be free from a 10% early withdrawal penalty from the Internal Revenue Services (IRS)5.
What are the Disadvantages to Using the 401(k) to Pay-off Debts?
While utilizing funds from a 401(k) Plan offers immediate upside, there are some long-term considerations and risk that disincentivize early withdrawal from a 401(k) plan. Disadvantages include:
- 10% Penalty – If a plan holder chooses to take out a loan before 60 years old or when they are unable to work, then their withdrawal is subject to 10% tax from the IRS7.
- Over-Loan Risk – Because of the ease of being able to take out a loan against a 401(k) Plan account, some holders may take out more than they can inevitably repay. The end result for these holders is an unpaid early withdrawal fee5.
- Unemployment Risk – If a holder takes out a loan and becomes unemployed, the time to repay their 401(k) Plan shortens to 60 days. The risk of being on the hook to pay without a stable income is compounded by the taxable interest placed on top of the required payments6.
- Economic Risks – Because 401(k) Plan investments are rooted in investments in the market, any economic instability can affect the valuation of the 401(k). Depending on the fund’s market performance, the loan may become de-valued5.
- Automatic Withdrawal – The remaining balance of the debtor in their account may be subject to automatic withdrawal if they fail to pay within the five-year repayment period that will be subject to an automatically applied 10% penalty9.
- Loan Denial – Some employers may restrict their funds to prevent employees from taking a loan against their 401(k)10.
- Loan Limits – Some 401(k) plans may institute loan limits, typically 50% of savings or $50,000, whichever is less. An account holder’s loan may be set up in increments but traditionally will not exceed 50% in total7.
Considering that the 401(k) Plan provides both advantages and disadvantages for early withdrawal, taking out a loan should require some personal contemplation on how best to handle it. Fund holders can look to the links below for more information on what to consider for your personal financial goals.