Should you pay off credit card debt with a 401(k) loan?

If you have credit card debt, it's important to understand the potential risks and benefits of tapping your retirement funds to pay it off. (iStock)

Financial experts often advise workers to avoid tapping into 401(k) accounts to cover life’s current expenses, urging them instead to leave the money in place, so they can rely on it, as intended, in retirement.

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While the advice may be sound in general, drawing on a 401(k) can make sense in certain situations.

Should you take a 401(k) loan to pay off credit card debt?

If borrowers understand the potential drawbacks, this type of loan can provide a sound strategy to escape high-interest credit card balances.

“Taking a loan can be a great way to pay down credit card debt, because even though there is an implied interest rate, that interest credit goes back into your own account,” said Greg Plechner, partner at Greenspring Advisors, a corporate retirement and wealth management firm.

Another positive: A 401(k) loan won’t become part of your credit report.

HOW TO GET A $50,000 PERSONAL LOAN

Most employers sponsoring 401(k) retirement plans allow employees to borrow from their accounts, but they aren’t required to do so.

Plan participants may borrow up to 50 percent of their vested funds, according to the IRS, with loans capped at $50,000. Those with balances under $20,000, however, may only be permitted to borrow up to $10,000.

Employees generally must repay loans – with interest – within five years, paying in equal monthly or quarterly installments. (Employees borrowing for a down payment on a home may be able to take longer to repay.)

Employers may add their own rules to the government regulations covering 401(k) loans.

For a 401(k) plan participant, the only net cost of going this route is the “opportunity cost” – the lost time that the money could be growing in the retirement plan – according to Plechner.

The risks of taking a 401(k) loan

Even though borrowers are essentially repaying themselves, it’s also important to remember that 401(k) loans don’t come without some risk.

“You want to make sure you’re secure in your job,” Plechner said. Borrowers who lose their jobs before repaying the loan are likely to find the remaining balance treated as income, subject to taxes. Plus, if the employee is younger than 59 ½, they can face a 10 percent early-withdrawal penalty.

HOW TO WIPE CREDIT CARD DEBT FAST

Since employers typically handle repayments through payroll deductions, they won’t be able to recoup the loan once the employee leaves the company, Plechner explained. The vast majority will issue a departing worker a 1099 tax form for the balance, he said.

The result? A $10,000 loan balance could shrink by thousands of dollars once income taxes and early-withdrawal penalties come into play.

(Note: Hardship withdrawals from 401(k) plans also are subject to income taxes and early-withdrawal penalties.)

Are there better options than 401(k) loans?

While 401(k) borrowers repay nine out of 10 loans, the default rate is high – more than 85 percent – among those ending employment with outstanding debt, according to a 2015 National Bureau of Economic Research working paper.

Consumers seeking to cut high-interest credit-card debt may want to consider other options as well. Plechner cited several, including:

  • Home equity loans. Mortgages and home equity loans remain at historically low rates, presenting an attractive borrowing opportunity for homeowners.
  • Unsecured personal loans. These typically carry higher interest than 401(k) loans but lower rates than credit cards – high single-digit percentages – according to Plechner.
  • Low-interest balance-transfer credit cards, which allow consumers to roll over funds from high-interest cards.
  • Family loans.

These options bring their own risks and benefits.

Consumers also can try to persuade their credit card company to lower an egregiously high interest rate.

Those experiencing a serious cash crunch might want to tap a 401(k) to avoid bankruptcy. They should bear in mind, though, that U.S. law protects most retirement plans from creditors in bankruptcy proceedings.

Any route that consumers might take to pay down credit card debt represents a short-term fix to an underlying problem, Plechner noted: People carrying credit-card balances are spending more than they make.

Consumers can address this, he said, by following a budget and reducing spending so they no longer rely on credit cards.