Should You Use a Loan From Your 401(k) to Eliminate Consumer Debt?

If you have accumulated some savings in a 401(k) plan while also racking up consumer debt you may be in a position to substantially reduce the interest payments you are making on your debts while earning a nice return on your retirement investments.

Before you decide to take this route though there are some things to consider.

1. Do you own a home?

If the answer to this questions is yes and you have some equity built up you're probably better off using a home equity loan to pay off your debts because it is an easier and less complex way to reduce the interest rate and payments on your consumer debt.

2. Will your employment be stable for the next 5 years?

Plan repayment terms vary but a common rule of thumb is non-home related loans from 401(k) plans have to be paid back within 5 years. Do not take out a loan amount that you do not think you'll be able to pay back within the plan repayment guidelines. Any money not repaid will be considered a distribution by the tax man and you will get hit with penalties and taxes that would negate any benefit to employing this strategy.

Also, you need to feel confident you won't be laid off, look for a new job elsewhere, or otherwise change employers for the amount of time it will take you to pay back the loan. If you leave the company most plans will require immediate repayment of the loan and any amount not repaid will be considered a distribution.

3. Will you be able to accommodate the repayments in your budget?

Unlike credit cards which give you the flexibility to vary payments. Typically repayment on loans from your 401(k) are fixed and deducted automatically from your paychecks. Before employing this strategy make sure your monthly budget will be able to accommodate the size of these payments and that you have the financial flexibility to take care of any unexpected expenses should the need arise.

4. Are you comfortable with the possible loss of return on your savings?

While you will be paying yourself interest on the loan you take, about 6% based on where interest rates are today, typically an investment in a stock fund would return more. So you have to decide if you will be able to emotionally handle a scenario were stocks take off and you're stuck with a cash return for a few of years.

5. What are the tax implications?

You will be repaying the loan with money that has already been taxed. When you withdraw money from your 401(k) in the form of distributions down the road those distributions will also be taxed. So you are being taxed twice on the earnings used to pay back the loan. Oftentimes if you earn a substantial salary then this strategy doesn't make financial sense unless your interest rates are exceptionally high.

At this point you may be thinking why would I ever employ this strategy. It seems too difficult and risky to implement. The reason is you could see substantial benefits to your finances if the math works for you.

Below is an example I use to demonstrate how you can figure out if paying off your debts this way is a wise decision.

Bill is 28 and has $10,000 of credit card debt. His salary has averaged $40,000 per year for the 5 years he's had his current job. He expects to remain with his employer for the next 5 years. He has saved 10% of his salary for the last 5 years and so he has $20,000 of savings.

The average rate of his credit card debt is 13% and the average rate of taxes he pays on his income is 20%.

If Bill paid off his credit cards without a loan over the next 5 years he'd pay $13,652.

Assuming Bill pays 6% interest on his loan his repayment will equal $13,382 over the next 5 years.

So Bill's gain from taking the loan is $3,652 (the amount he saved in interest payments) + $3,382 (the amount he payed himself in interest) for a total of $7,034.

Bill's cost are as follows. If he invested the money in an S&P 500 fund and earned 12% he would have $17,623 at the end of 5 years.

Because he has an average tax burden of 20% of income he'll have to earn $12,000 to pay back the $10,000 loan.

The total cost to Bill for employing this strategy is $4,241 (the difference between $17,623 - $13,382) + $2,000 (for the taxes he'll pay) for a total of $6,241.

So Bill's net savings from employing this strategy is $7,034 - $6,241 = $793.

$793 is nothing to sneeze at but Bill may still not want to take out the loan if he's unsure about his employment, expects his income to rise substantially, or if he's not comfortable he'll be able to afford the monthly repayment of $193.33.

Conversely, if Bill was a more conservative investor and expected a lower return on his money, if the average interest rate on his debt was higher, or if he expected his tax rate to decrease he would see more substantial savings from employing this plan.

There is no universally right answer to the question of whether or not to use a 401(k) loan to pay off consumer debt. Use the example above as a framework to figure out if the numbers work for you and then take the plunge if you feel comfortable.

Steve Miller is devoted to helping people eradicate their debt. The web-site he co-founded http://www.debtmd.com offers free debt elimination software individuals can use to create a personal debt elimination plan in 9 minutes and 34 seconds.

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