At a Glance

Carrying too much debt is a problem that can affect you in several other areas. At first glance, using funds from your 401(k) plan to pay off that debt may seem like a good idea, particularly if you have high-interest credit cards. It’s your money. Why not use it? That’s the question we’ll attempt to answer for you today. Here are the pros and cons of using a 401(k) loan to pay off debt:

Pros of Borrowing from 401(k) to Pay Off Debt

As we mentioned above, taking out a loan from your 401(k) plan is essentially borrowing your own money. You won’t need to go through an approval process with a lender to borrow the money. If you set up online access, there’s likely an option on the website to do this quickly and conveniently. That’s both good and bad, but we’ll keep it in the “pro” category. Other pros include:

  • Flexible Repayment Options: Fund administrators want you to pay back your 401(k) loan quickly and painlessly, so they offer flexible repayment options. There are no early repayment fees, and you can set up direct debits to ensure you don’t miss a payment.
  • Low or Non-Existent Lending Costs: You may be charged a small origination fee and there might be an administrative charge, but 401(k) loans are the lowest cost lending vehicle you’ll find. If you must borrow to pay off debt, this is likely the best option.
  • Neutral Impact on Retirement: A common misconception is that borrowing from your 401(k) will have a negative impact on your retirement fund. That only happens if you do it during a bull market. Otherwise, the impact is neutral because you pay the money back with interest. We’ll get into this in more detail below.

Cons of Using 401(k) to Pay Off Debt

When the stock market is consistently rising it’s known as a “bull market.” That means the funds in your 401(k) plan are increasing in value. Taking them out while that is happening could cost you those potential gains. This is the most common argument against 401(k) loans, but it only affects you when the market is bullish. Other legitimate “cons” include the following:

  • Risk of Job Loss: As we all learned in 2020, no job is guaranteed to be secure. If you lose your job while you still owe money on a 401(k) loan, the IRS requires you to pay off the remaining balance within sixty days. Failing to do that will reclassify the loan as an early withdrawal and you’ll be subject to a 10% fee and income taxes.
  • The S&P 500 is Up 20% This Year: The timing for a 401(k) loan should be carefully considered. The S&P 500 is up 20% this year, so taking funds from your retirement account is probably not the best option. A personal loan, despite the higher interest rate, would be more cost-effective.

Commonly Asked Questions

Does taking a loan from your 401k hurt your credit?

No, there’s no credit check to qualify for a 401(k) loan, and credit reporting agencies don’t use your retirement savings as a variable when they calculate your credit score.

How does a 401k loan affect your tax return?

In most circumstances, a 401(k) loan will not affect your tax return. If you lose your job and can’t repay the loan, the IRS may reclassify it as an early withdrawal and tax you on it.

Can you borrow from 401k without penalty?

It’s your money. No one will charge you a fee to borrow it, as long as you pay it back.

Is it a bad idea to use 401k to pay off debt?

No. In most cases, it’s a good idea to take a 401(k) loan to pay off debt because it’s the lowest-cost lending option you’ll find, and you can typically use it to pay off debt fast. Just don’t do it during a bull market or if you think you’ll lose your job soon.