Are you making payments on your credit card balances but not making much progress in paying them down? If high interest debt is causing you to lose sleep, it can be really tempting to take a loan from your retirement plan to pay it off. It could be the step that gets you back on track financially or sends you off the financial cliff. This is a high-risk decision. How do you decide if it makes sense for you?
Many employees ask themselves this question
Every day, my fellow planners and I talk to employees on our Financial Helpline who are contemplating taking a retirement plan loan to pay off debts. There’s no “one size fits all” answer to whether an employee could benefit or be hurt. Is it ever OK to borrow from your 401(k)? I’ve worked with employees who used a retirement plan loan to gain some financial wiggle room and pay off their debt for good. I’ve also talked to employees who took loans, only to call again for another a loan in a year because they built up large credit card balances again.
When to even consider a retirement loan to pay off debt?
The first question to ask yourself is whether you’ve exhausted your other options. A 401(k) loan should be the last thing you consider, not the first. Strategies you could try before taking a retirement plan loan include:
- Initiating a balance transfer to a zero or lower interest card. This strategy can work well for those who have good credit but a high balance. Keep paying the same amount every month and your debt will be paid faster. See here for the pros and cons of balance transfers and here for when it may make sense.
- Sell something. Use the proceeds to pay off some of the debt. So many of us have a lot of stuff we don’t use anymore. Is there anything you can sell to raise some extra cash? My fellow planner Kelley Long once sold almost everything she owned online, including her car, to raise cash before a big move. Another strategy I mention a lot: have a garage sale.
- Find a side gig. Do you have some time during a typical week to earn a little extra cash? Even $50 or $100 dollars per month can help you pay more than the minimum on your cards and blast your debt down. (Use this calculator to see how this works.)
Benefits of a 401(k) loan to pay off credit cards
If you’re considering a 401(k) loan to pay off credit cards, chances are that you think your credit card debt has gotten out of hand. Wouldn’t it be great to get those balances down to zero or at least to a point that’s manageable? If you’re up to your neck in credit card debt, the benefits of borrowing from your retirement plan look pretty attractive:
- You’ll pay interest to yourself, generally at a much lower rate than your credit card interest rates.
- Loan payments come out of your paycheck, so as long as you’re working for the same company, repayment is automatic.
- You’re likely to pay off the total balance sooner, since regular 401(k) loans have a maximum five year term.
- Your loan will not be reported to credit bureaus, so there’s no effect on your credit score.
The high risks of using a 401(k) loan to pay off other debt
This sounds too good to be true, right? Before you initiate that loan, make sure you know all the risks. There are many:
- Big taxes and penalties if you leave or lose your job while the loan is outstanding. If you’re planning to leave your job during the loan period, it’s usually best not to take the loan. Most retirement plans require that retirement plan loans be paid back within a short time frame after an employee is no longer employed with the company. If you can’t pay it back, the unpaid loan balance is reported to the IRS as a retirement plan distribution and is taxable to you plus an additional 10 percent penalty if you’re under age 59 1/2. However, you may be able to salvage the situation by contributing the balance amount to an IRA rollover before you file taxes for that tax year.
- You will lose out on growth if the market goes up. Think of 2017, when the S&P 500 increased nearly 19 percent. The power of compounding grows the longer a profitable investment is held. You’ll have the most success if you contribute, invest wisely, and let your investment returns compound over a very long period of time.
- If you don’t radically change your cash management habits, you could run up big credit card balances again. Then you’d have the 401(k) loan and new credit card balances to pay. It could be a slippery slope. If you’ve got access to financial coaching in your company’s workplace financial wellness program, make sure to take advantage of it. Working with a financial coach can help you get a better handle on your cash flow so the situation that prompted you to take a retirement plan loan doesn’t happen again.
- You could be stuck with the 401(k) loan even after bankruptcy. If you aren’t able to pay off all your debt with the loan and end up having to file for bankruptcy protection, you’ll still have to pay off your 401(k) loan. Retirement plan loans aren’t discharged in bankruptcy.
It’s a last resort, not a first source of cash
Before taking a retirement plan loan to pay off credit cards, make sure you’ve done absolutely everything you can to get on top of your credit card debt and that you understand the substantial risks involved. If you’ve got access to a financial wellness program at your company, work with a financial coach to evaluate your situation clearly and weigh the pros and cons. Consider limiting yourself to one loan – and make a commitment to get a handle on your cash flow so you won’t be compelled to consider another one.
One way to really get ahead
By the time you’ve paid off your retirement plan loan, you’ve probably gotten used to the loan payments coming out of your paycheck. Now that you’re done, set up automatic deposits from your paycheck to a savings or money market account for the same amount. That way you’ll build up emergency savings so you hopefully won’t have to build up credit card balances or take a retirement plan loan again!
A version of this post was originally published on Forbes.