Should you borrow from your 401(k) or 403(b) for debt relief?

These days approximately 80% of all workers with a 401(k) plan can borrow from their plans for whatever purpose they choose. In addition, a growing number of 403(b) plan participants are now able to do the same. If you have been diligently putting away a portion of your salary over the past few years and your company has made some type of matching to your savings, the chances are that puts a lot of money at your fingertips, barring recent stock exchange fluctuations.



Would it not make sense than to use this money for paying off your credit card debt or perhaps use these monies, take a trip or buy something? The question then becomes, “Does it make sense to take out a loan from your 401(k) or 403(b) for these reasons?”



Let’s look at it. In today’s environment, a typical 401(k) plan will allow you to borrow up to half your vested balance, however not more than $50,000. Still other plans might limit this amount depending upon the purpose of the loan, such as for medical expenses, educational expenses or the purchase of a new home.

To start with, this is your money you must pay back to your plan, along with interest, over a five year period. However, since you will be paying the interest to yourself, it is not an additional cost. Just think of it as forced savings. However, if you elect to not pay the loan back, you will owe income tax on those monies, plus a 10% early withdrawal penalty to the IRS.



From our view, there are three big negatives to borrowing from your 401(k) or 403(b) plans to pay off your debt. First, you will be giving up the tax-free compounding of all monies you withdraw. Second, you will be replacing pretax money with after-tax money. Therefore, if you are in the say the 27% tax bracket, it will take $1.40 in salary to replace every $1 you withdrew from your account. Finally, if you leave your current employer, you will probably have to pay the loan back immediately. We believe these three negatives outweigh any positive to borrowing from your retirement plan to pay off your debt. Instead, we suggest a debt reduction or debt relief company to help you reduce debt or pay off your credit cards.

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