When It Makes Sense to Use a 401k to Pay Off a Credit Card

Your 401(k) is designed to be used for long-term retirement savings. In fact, there are a variety of rule and regulations surrounding 401(k)s to emphasize that as their goal. You’re limited in how much you are allowed to contribute each year, and you cannot withdraw from a 401(k) until you turn 59½.

A 401(k) does offer the option to take a loan from the balance without paying the tax penalties. Therefore, it is an option to help you pay off your credit cards.

However, it is almost never a good idea to do so because of the rules and pitfalls surrounding 401(k) loans. That’s not to mention the huge effect that taking a 401(k) loan will have on your retirement savings.

How Do 401(k)s Work?

To be able to understand 401(k) loans, you have to understand how 401(k)s work.

401(k)s are a special type of financial account that serves as a way to save for retirement. 401(k)s are offered by employers as a benefit for their employees. Though you can open an IRA to save for retirement regardless of your employment situation, you only have access to a 401(k) through your job. That means if you lose your job or change employers, you might lose access to a 401(k) or have to change 401(k) plans.

You are only allowed to contribute a certain amount of money to a 401(k) each year. For 2020 and 2021, that amount is $19,500, or your total annual income, whichever is less. However, your employer may place additional limits on your contributions.

Once you’ve put money in your 401(k), you cannot withdraw it until you turn 59½. If you do decide to withdraw it before reaching that age, you’ll have to pay a 10% penalty on any amount you withdraw.

In exchange for contributing money to a 401(k) and locking it away until retirement, you get to deduce your contributions from your taxes. You can reduce your taxable income by the amount that you contribute to your 401(k).

Consider this example:

In 2020, you have $50,000 in taxable income after your deductions. Your total tax bill for the year comes to $8,238.75. If, during the year, you contributed $5,000 to your 401(k), it would bring your taxable income down to $45,000. Because you are taxed on $5,000 less in income, your total tax bill would instead be $6,988.75. That’s a savings of $1,250 in taxes.

When you withdraw from the account in retirement, you’ll pay income taxes on the withdrawals. Usually, this is to your benefit since your tax rate will be lower in retirement than it is in your earning years.

401(k) Loans and Rules

If you do decide to take a 401(k) loan, there are a lot of rules to be aware of.

The first is that you are only allowed to take a loan of $50,000 or 50% of the account’s balance, whichever is less.

When you take the loan from your 401(k), the amount is immediately deducted from your 401(k)’s balance. That means that your retirement savings will shrink, and the amount withdrawn will no longer be earning a return in your 401(k). This loss of growth can significantly affect your account’s balance when you retire.

Most plans allow you to take a 401(k) loan for any reason, but some will restrict the loan to certain purposes. Once you’ve taken the loan, you’ll have 5 years to pay it back. If you took the loan to help buy a house, you can extend it to 10-15 years.

The big catch for 401(k) loans is that you must pay the loan back, in full, if your employment changes. You’ll have 60 days from the end of your current job to pay the loan back. If you don’t, you’ll be on the hook for income taxes on the outstanding amount, plus a 10% early withdrawal penalty.

The same is true for situations where you default on the loan. If you miss a payment, you’ll be on the hook for taxes and penalties on the amount you have left to pay back.

Worse, in both these cases, you can never get the money withdrawn back into your 401(k). That tax-advantaged space is lost permanently.

This example will show the power of compounding in a 401(k).

You are 25 years old and have decided to start contributing to your 401(k). You plan to contribute $1,000 per year, every year until you turn 60. When you turn 60, you’ll look at your balance and decide when you want to retire. Until then, you’ll keep your 401(k)’s balance invested in the stock market.

Assuming your investments earn 9% returns each year, you’ll have just over $236,000 in your 401(k) when you turn 60.

Now, imagine if you decide to take out a $10,000 401(k) loan when you are 40. You pay it back, $1,000 per year, over the next 10 years. When you turn 60, your 401(k)’s balance will be only $216,000. Your $10,000 loan reduced your retirement savings by $20,000.

Another thing to note is that even though you’re borrowing money from yourself, you still have to pay interest on the loan. The interest will just be returned to your 401(k). Usually, the rate is based on market rates and you cannot set it to zero percent.

Should You Use a 401(k) Loan to Pay Off Credit Cards?

In short, you should not use a 401(k) loan to pay off credit card debt. Even though credit cards charge a lot of interest, the costs and risks of a 401(k) loan make it a bad idea.

If you take out a 401(k) loan to pay off a credit card, you’re hurting your retirement to reduce current costs. Plus, if something goes wrong and you miss a payment or lose your job, the costs get even larger.

The only situation in which it makes sense to take a 401(k) loan is if you are on the verge of bankruptcy. Even then, it might not be the best idea because 401(k) balances can be protected from bankruptcies. Instead, you should try another strategy to reduce your monthly payments and interest charges.

Other Ways to Consolidate Debt

Consolidating debt is a good way to both reduce your interest rates and lower your monthly payments.

When you consolidate existing debts, you take out a new loan to pay off your old loans. This means you can turn multiple monthly bills (and minimum payments) into one. That makes it easier to manage your debt. You can also use a lower interest loan to consolidate existing debts. That means you’ll save money by paying less interest.

Though 401(k) loans are not the best way to consolidate credit card debts, there are other options that you can try.

Personal Loans

Personal loans are a good way to consolidate existing debts. Like credit cards, many personal loans are unsecured debts. You don’t need to come up with collateral to apply for a personal loan. Though they charge more interest than a car loan, mortgage, or other secured loan does, their rates are far lower than credit card rates.

You can get a personal loan from a huge variety of lenders. Some online-only lenders offer low rates and use unique lending criteria so you can maximize your chances of getting approved for a loan. You can also find lenders willing to offering loans as large as $100,000 so you can consolidate even the largest credit card debts.

Lenders offer personal loans with payback periods of as long as seven years. That gives you the flexibility to pay your loan back over time.

Balance Transfer Credit Cards

Another way to consolidate your existing credit card debts is to open a balance transfer credit card. Many credit card companies allow you to transfer existing credit card balances to your new card. Usually, there is a small fee for this service, around 3-5% of the amount transferred.

When you transfer existing credit card balances to a new card, you go from having multiple bills to just one. That makes it easier to handle your monthly minim payments.

The best way to consolidate your debts with a balance transfer card is by looking for credit cards with promotion interest rates. There are many cards that will give you an introductory period with no interest charges. This period usually lasts between 12 and 18 months.

Even after paying the balance transfer fee, not paying interest for a year or more can save you a lot of money. If you manage to pay off your balance in full, you won’t pay any more interest. These deals can be a great way to get back on your feet financially since they help you save so much money.

Conclusion

A 401(k) is a great retirement savings vehicle, that offers the option to take a loan from the balance. Despite this feature, it is usually a bad idea to take a 401(k) loan, even if you have other debts to pay, the costs of a 401(k) loan exceed the benefits.