How to Borrow from Your 401(k) to Pay Off Your Debt
by Philip Rollo
I’ve read the snowball vs. avalanche method of paying off debt, and I figured I’d tell you about my own personal method — or at least, the one that I’ve used a couple of times over the last few years that has helped me tons. This method requires that you’ve been saving for retirement via a 401(k).
My stats: I’m 28, working full-time with a good company, and graduated with about $22,000 in student debt. I’m not rolling in the cash (I earn about $44,000 before taxes), and I don’t have outside help, and never have. The ‘rents cut me off at 18. It was an “I did it, so you can do it” sort of scenario.
I managed to avoid all the economic downturn problems by keeping the full-time job I had during school after I graduated, which meant that I started my 401(k) fairly early for someone in our age group. Interestingly, that college job was as a 401(k) customer service rep, so I knew early on the importance of starting a retirement savings plan as early as possible. I knew that over time, the savings would pay huge dividends (pun intended). In my training for said job, we were taught that taking money out of a 401(k) early (pre-retirement age), for almost any reason, is “bad.” And in a lot of ways, I agree with this view, but having a 401(k) nest egg at an early age, while still supporting some debt, has provided me with an interesting alternative to the snow/avalanche equations.
Recently, I paid off my largest school loan ($16,000) with a 401(k) loan. I don’t know if most people are familiar with the option, but a 401(k) loan allows someone to borrow money out of a 401(k) (as opposed to against it), which means that there is no credit check or anything credit-related going on. Further, while there is interest that must be paid on a 401(k) loan, it is paid back to the borrowers own account.
In explaining this to customers, at this point people usually ask “Why should I pay interest on money I’m borrowing from myself?” Quite simply, because the IRS says so. They require that there be an interest component in a 401(k) loan simply so that you’re not utterly crippling whatever retirement savings that you’ve managed to scrape together. In reality, that interest rate is going to be much lower than what a well diversified portfolio is going to earn on the market, but it’s a) better than nothing, and b) better than paying a bank what is probably a much higher rate. The student loan I just killed off had an interest rate of 7.5%, and my 401(k) loan is only 3.75%. Sweet!
Further, the loan payments from a 401(k) loan comes directly out of the paycheck, as opposed to from a checking account, so by the time I get my paycheck, I don’t have to think about the payment being on time or late or anything. No late payments, ever.
I have used this method a couple of times. This most recent loan was definitely the largest so far, but previously, I have taken smaller, shorter term loans to pay off high interest credit cards, and to pay off my car. I’m talking $1,500 over 12 months, or $1,200 over 9 month, that sort of thing. Each company has its own rules about how much can be borrowed and how you can structure the terms of the loan, but in my experience (and I’ve seen a lot of plans) most plans are pretty flexible. Sometimes there is a fee for taking a loan out (smaller the company, generally the higher the fee) usually around $35 to $50, and it’s usually taken out of the 401(k) account directly, so it’s not hitting your paycheck.
The biggest thing to watch out for, by far, is if you leave employment while you have a loan outstanding. It doesn’t matter how you’ve left your now former employer, whether voluntary or not, but when you do, you will have to either pay back that loan in full (most companies’ plans give you a 90 day window), or you have to pay taxes on that outstanding balance. Taxes means you will owe the IRS whatever your normal income tax is, based on your tax bracket (and remember, that loan balance will count as income in that tax year, so depending on your income and how big the loan is, getting bumped up into a new, higher tax bracket is very possible) plus a 10 percent early withdrawal penalty on that outstanding balance.
So the 401(k) loan is not for everyone. Ideally you’d be somewhat younger, and working a stable job where you’ve started your 401(k). Me, I’ve only ever contributed the minimum amount to get my full employer match, so it has just sort of worked out for me — the rest of my paycheck has been mostly going to rent, beer, and traveling. I’m bad at diligently paying down debt.
I would definitely NOT recommend using these for anything frivolous or unnecessary. I’ve seen lot’s of people use them to buy a nicer car, when they already drive a perfectly good beater, just because they did a quarterly check up on the 401(k), saw the bigger than expected number and thought “I’m rich!” No, you’re not. But if you leave it alone, then when you turn 59 1/2, you will be. So be disciplined! Don’t buy things that you would otherwise not be able to afford! This can be an interesting way to get rid of some nasty bills. If you’re killing debt, I think that’s a pretty solid use.
Cheers and happy savings!