Is it a Good Idea to use a 401(k) Loan to Pay Off Your Credit Card Debt?

Credit card debt can be overwhelming, and when you need debt relief, it’s natural to want to explore your options.

A 401(k) is one option you may have available to consolidate and refinance credit card debt. If you participate in a 401(k) plan that offers loans, 401(k) loans have the advantage of being fairly inexpensive and easy to get. However, there are risks and potential costs you should understand before taking out a 401(k) loan. 

What Is a 401(k) Loan?

A 401(k) loan is a loan made from an employee's balance in their employer's 401(k) retirement plan. As with any other loan, you have to pay the money back on a regular schedule over time, and you have to pay interest on the amount you've borrowed. 

Because 401(k) loans are made from tax-advantaged retirement plans, you have to meet certain conditions to avoid having the loan be considered a taxable distribution from the plan. 

Not all 401(k) plans offer participants the option of borrowing against their balances. So, being able to even consider a 401(k) loan depends primarily on two things:

• You have to participate in an employer-sponsored 401(k) plan

• Your plan has to offer participants the option of borrowing against their balance in the plan

Check with the person or department at work who coordinates your 401(k) plan to find out if you're eligible to borrow against it. 

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How Does a 401(k) Loan Work?

Once you get a 401(k) loan, it works like any other loans. You borrow a set amount, and then repay it over time.

Because a 401(k) plan offers tax advantages, the IRS sets rules by which these plans have to operate. Employers have to follow these rules, but within those rules, they can also set their own conditions for how employees may use the plan. 

Under IRS rules, there's an important difference between borrowing against your 401(k) balance and taking a distribution from that plan. Distributions from tax-deferred retirement plans are considered taxable income. Also, if you take a distribution from your 401(k) before you’re 59 ½, you might also have to pay a 10% early distribution penalty. 

IRS rules allow participants to borrow against their balances in 401(k) plans under certain conditions. If those conditions aren't met, the loan may be considered a distribution from the plan. That would trigger tax consequences. 

How much can you borrow from a 401(k) plan?

One condition the IRS places on 401(k) loans is how much you can borrow.

You are allowed to borrow the lesser of:

• 50% of your vested account balance

• $50,000

So, let's say Jerry and Bobby participate in the same 401(k) plan. Jerry has a balance of $200,000 in the plan and Bobby has $60,000.

Half of Jerry's balance is $100,000. That exceeds the $50,000 maximum, so the most Jerry can borrow is $50,000.

Half of Bobby's balance is $30,000. Since this is less than $50,000, the most he can borrow is $30,000.

The borrowing limits apply to the total of all outstanding 401(k) loans that you might have. 

Interest and repayment terms for 401(k) loans

You can have a maximum of five years to repay a 401(k) loan. You or the plan administrator may opt for a shorter term than that, but it can't be longer.

Loans must be repaid with a series of substantially equal payments over the loan term. Those payments must include principal and interest, and must be made at least quarterly. 

All 401(k) loans must charge interest. But your plan administrator has some discretion over the interest rate. 401(k) loan rates are normally low, such as 1-2% over the prime interest rate.  

How a 401(k) Loan Differs from a Hardship Withdrawal

The IRS gives employers the option to allow hardship withdrawals from their plans. These are withdrawals made prior to normal retirement age under conditions of "immediate and heavy financial need." Examples might include:

• Necessary medical care

• Funeral expenses for the plan participant, spouse, children, dependents or beneficiaries

• Payments to prevent eviction or foreclosure

You'd have to ask your plan administrator whether you'd qualify for a hardship withdrawal. Paying off credit card debt isn't listed by the IRS as a standard reason for hardship withdrawals, so you might not qualify for one if that's why you need the money.. 

If you do qualify, hardship withdrawals are considered taxable distributions. You might also have to pay a 10% early distribution penalty. 

So, under some circumstances a loan might be preferable to a hardship withdrawal if it allows you to avoid tax consequences. Also, with a loan, you can ultimately put the money back into your retirement plan on top of making regular contributions to the plan. 

A hardship withdrawal may not be repaid.

Why You Might Use a 401(k) Loan to Pay Off Credit Card Debt

A 401(k) loan can be useful for paying off credit card debt for a few reasons:

• 401(k) loans don't typically require a credit check. Thus they can be an option even if you couldn't qualify for a traditional loan.

• 401(k) loans are also not typically reported to credit bureaus, so the new debt won't affect your credit score.

• Because no credit check is required, your employer is already aware of your employment status, and you're borrowing the money from your own retirement savings, 401(k) loans can generally be processed faster than many traditional loans.

• With typically very low interest rates, 401(k) loans tend to be much cheaper than credit card debt. They are also generally cheaper than the average personal loan. With a 401(k) loan that interest is paid into your own 401(k) account—not to a lender.

This last point gets to the heart of the reason for refinancing credit card debt. Lowering your interest rate allows more of your payments to go to paying off debt rather than interest charges. This could help you get out of credit card debt faster.

401(k) Loan Costs

The costs of a 401(k) loan are very different from those of a traditional loan. There are advantages and disadvantages to those differences. 

Interest and fees

On the plus side, 401(k) loan interest is paid into your own 401(k) account.

The 401(k) plan administrator may charge a fee for initiating a loan. This is also true of many traditional loans.

Opportunity costs

Where 401(k) loans have costs that traditional loans don't is in their potential impact on your retirement savings. 

When you borrow from your 401(k) balance, that money is no longer invested. So, you'll miss out on market returns until you repay the money. The compounding effect of investment returns can magnify this opportunity cost. 

Also, repaying the loan may impact your ability to make new contributions to the plan over the next few years. If this happens, you'll not just miss the potential investment returns on those contributions. You'll also miss out on the tax advantage of those new contributions to the plan.

The problem with these opportunity costs is that you can't really know how much they'll amount to until after the fact. A big reason for borrowing to pay off credit card debt is to save money by paying a lower interest rate. However, you can't know until after the fact whether your investment returns would have been worth more or less than the credit card interest saved. 

As a result, when it comes to a cost comparison, using a 401(k) loan to pay off credit card debt involves making an educated guess. The benefit can't be calculated precisely. 

Tax Costs of Using a 401(k) Loan to Pay Off Credit Card Debt

Taking out a 401(k) loan diminishes some of the tax advantage of participating in a retirement plan. It also incurs the risk of an additional tax penalty.

In a traditional 401(k) plan, the money you put in hasn't been taxed. However, when you borrow against that money, you'll be paying it back with after-tax dollars from your paycheck. 

Then you'll pay taxes on withdrawals in retirement. 

A 401(k) loan reduces the tax advantage of participating in the plan.

You also face the risk of triggering income taxes plus a 10% early distribution penalty. This could happen in a couple ways:

• If you fail to repay your loan within the time limit or make too many late payments, the unpaid amount may be categorized as a distribution rather than a loan. That money would then be subject to ordinary income taxes. Also, if you're younger than 59 1/2 years old, you'd face the additional 10% early distribution penalty.

• If you leave your job for any reason, your employer can demand immediate repayment of the outstanding balance on your 401(k) loan. If you can't repay that amount, it'll be considered a distribution. This would have the same impact described above. The amount you owe would be subject to income tax, and if you're younger than 59 1/2 you'd also face the 10% penalty. 

You can avoid some of these tax costs by repaying the loan on schedule. 

As with any loan, before you borrow you should figure out a budget that will allow you to make the required payments. With a 401(k) loan, you also have to assess the likelihood that you'll remain with your employer throughout the loan term. 

Using a 401(k) Loan to Pay Off Credit Card Debt: Pros and Cons

The following table summarizes some of the pros and cons for using a 401(k) loan to pay off credit card debt:

Alternatives to Using a 401(k) Loans to Pay Off Credit Card Debt

Here are some alternatives to 401k loans for consolidating credit card debt,  

• Debt consolidation loan: Often open to those with lower credit scores

• Home equity loan: Available to homeowners with sufficient equity

• Using an emergency fund or other savings to pay off debt: Depending on your resources and future needs.

Before you take out a 401(k) loan, you should research other loan sources to learn the cost of the alternatives. That way, you can consider the costs and risks of a 401(k) loan compared to other loans to make an informed decision.