Should I use Retirement Savings to Eliminate Debt?

When feeling overwhelmed with high-interest credit card debt, you may be tempted by the idea of borrowing from your retirement accounts to pay it off quickly. Is this possible? If so, is this really a good idea?

The majority of 401(k) plans allow participants to take a loan against their account, typically with a maximum loan amount up to 50% of the account value, or $50,000, whichever is smaller. The interest rate should be considerably lower than the rate on the credit cards, which can be a nice benefit when you are struggling to pay your debt. In addition to the interest rate being cheaper, the interest is actually being paid to yourself as opposed to the credit card company.

Sounds like a slam dunk, right? Well, not so fast. It is important to be educated on the potential benefits as well as the potential drawbacks.

While the loan and interest is being paid back to yourself, it is repaid with after-tax dollars and that means the interest will be taxed again when it comes time to take distributions from your 401(k) in retirement.

Additionally, you are required to pay back the loan in five years or less and if you quit or lose your job prior to full repayment, it will likely be necessary to pay the entire outstanding balance immediately. If you do not repay the loan under these guidelines, the amount of the loan will be treated as a distribution from your account. This means that you will be taxed on the amount at your standard income tax rate, as well as the possibility of being assessed an additional 10% penalty for early withdrawal if you are under the age of 59 ½.

For these reasons, borrowing from your 401(k) should often be considered as a last resort. With the proper knowledge, you will be able to make the decision that is best given your circumstances.

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