Why you should never borrow from your 401(k) to pay off debt

If you need to pay off your debt, options other than tapping into your 401(k) may be better in the long-run. (iStock)

The average 401(k) account has a balance of just over $103,000, according to data from Fidelity. While this type of fund is a form of retirement savings, some plans let you tap into it sooner with a 401(k) loan. While loan structures vary, many allow you to borrow up to half of your vested funds to be paid back within five years.

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You could use this money to pay down debt, but is it a good idea?

“I don't suggest that my clients consider borrowing from their 401(k),” said Danielle Harrison, assistant vice president of wealth management at Simmons Bank in Columbia, Mo. “Many individuals feel as if they are just paying themselves interest on their money, so it is the best loan out there, but I look at it very differently.”

The disadvantages of using your 401(k) for debt

Your 401(k) is intended to fund your retirement. “With most companies no longer offering a pension, employees are responsible for their own retirement savings and the majority aren’t saving enough to maintain their current lifestyle in retirement,” Harrison said.

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When you withdraw from your account, you lose out on the earnings you could have received, and your balance may not reach the level you should have in your 401(k). In addition, you are paying the loan back with after-tax money, essentially paying double taxes, said Harrison.

More bad news: If you don’t pay the loan back on time, the outstanding amount will be considered a withdrawal and you will have to pay income tax on the amount along with the potential of a 10 percent penalty. And borrowing from a 401(k) could put you in a difficult situation.

“If you are fired, say due to a merger, or you leave, the plan terminates,” said Harrison. “You will have a limited amount of time to pay the entire balance off or you will be faced with ordinary income tax and potential penalties. This also may cause individuals to have to stick out a job that they are miserable at because if not they will be forced to pay back the funds.”

There are a few advantages to leaning on your 401(k)

While most financial planners advise against this type of method of paying off debt, it does have some advantages. First, no loan application or minimum credit score is necessary, which can be good if your credit history isn’t perfect. In addition, interest rates can be lower than other types of debt consolidation loans, and it goes to you instead of a bank or credit union.

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“I worked for many years administering 401(k) plans and saw many cases where borrowing from 401(k)s ended up terribly for the client,” said certified financial planner Mark Wilson of MILE Wealth Management in Irvine, Calif. "My opinion at that time was that 401(k) loans were toxic. Then I needed some additional funds to help with the purchase of our first home, and a loan from my 401(k) came to the rescue. For those that are disciplined, a loan from a 401(k) plan used to pay off high-interest debt can work out great.”

Alternative ways to pay off debt

Certified financial planner Kristi C. Sullivan of Denver, Colo.-based Sullivan Financial Planning, however, urged clients to find alternative options: “Your grandfather wasn't allowed to borrow from his pension to cover up his overspending,” she said. “No one is allowed to take money from their future Social Security payments to buy a house. Find a way to spend less, create better money habits going forward, and remember, your someday-elderly self is relying on you to save money for his future.”

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If your debt is due to credit cards, Sullivan said old-fashioned budgeting and cutting back is the answer. “Drive a less expensive car,” she said. “Examine your rent or house payment and make some hard decisions.”

You can also get a side hustle to pay down debt, Sullivan added. “Unemployment is at an all-time low and gig opportunities abound,” she said. “Even six months of extra work can make a huge dent in debt.”

If you do decide you to go with financing and own property, a home equity loan may be a good option. Or if your credit is strong, some lenders offer personal loans for debt consolidation. These options may be better than a 401(k) loan because they don’t impact your retirement goals. Whatever you choose, though, make sure to focus on your behaviors.

“If the [401(k)] loan simply gives access to rack up more debt, this is a terrible idea,” said Wilson. “Tread lightly when using 401(k) loans.”