Paying Off Debt With a 401k Loan

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If you’ve considered paying off debt with a 401k loan I urge you to think again. Despite the many advantages this option offers, there are some heavy downsides that need to be carefully considered.

Obviously there are some upsides to taking this option, or so many people wouldn’t be doing it. The best of the upsides are that you have a very low interest rate, and that the interest you do pay goes back into your retirement savings account. When you have no other source of funding this is also definitely preferable to making an early withdrawal from your account.

When you make a withdrawal before reaching retirement age you have to pay taxes on your withdrawal plus a ten percent early withdrawal penalty, which can easily total up to thirty percent or more of your retirement savings. This is a lot of money to lose and means you’ll have a much smaller nest egg.

If you decide to take a 401k loan then you have five years to repay the money you’ve borrowed, and if you fail to repay it in time the balance is treated as though you cashed out, meaning you owe the taxes and the ten percent withdrawal penalty. If you lose your job, or quit your job, during the time you are making your payments the balance becomes due and you have a short period of time, approximately a month, to repay the balance in full or it is treated as though you cashed out in the first place.

For these reasons this is something that’s only recommended you do if you have no other option for funding. For something like paying off debt, which you could do through normal payments, it’s not worth the risk. Yes, you could have a lower interest rate, which you would be paying into your account, however that interest rate could rise dramatically if something unexpected occurs and you have to treat your 401k loan as though you cashed out and you lose a great deal of your money to taxes and that ten percent penalty.

Because of these high risks for something like paying off debt it’s not recommended that you take a 401k loan.

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