Should you pay off your credit cards with a 401 (k) loan?

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Are you making payments on your credit card balances, but not making a lot of progress paying them off? If high interest debt is causing you to lose sleep, it can be very tempting to take out a loan from your retirement plan to pay it off. It could be the step that gets you back on track financially or gets you off the financial cliff. It is a high risk decision. How do you decide if this makes sense to you?

Many employees are asking this question

Every day, my fellow planners and I talk to employees on our financial helpline who are considering taking out a retirement loan to pay off debt. There is no “one size fits all” answer as to whether an employee could benefit or suffer the consequences. Is it still okay to borrow from your 401 (k)? I have worked with employees who have used a retirement plan loan to gain financial leeway and pay off their debt for good. I have also spoken to employees who have taken out loans, to apply for a loan again within the year, as they again accumulated large credit card balances.

When to consider a retirement loan to repay your debts?

The first question to ask yourself is whether you have exhausted your other options. A 401 (k) loan should be the last thing on your mind, not the first. Strategies you might try before taking out a retirement plan loan include:

– Initiating a balance transfer to a zero or lower interest card. This strategy can work well for those who have good credit but a high balance. Keep paying the same amount every month and your debt will be paid off faster. See here for the pros and cons of balance transfers and here for when it might make sense.

Sell ​​something and use the proceeds to pay off part of the debt. A lot of us have a lot of stuff that we don’t use anymore. Is there anything you can sell to raise some extra cash? My fellow planner Kelley Long has sold almost everything she owned online, including her car, to raise money before a big move. Another strategy I talk about a lot: having a garage sale.

Find a concert nearby. Do you have time in a typical week to earn a little extra money? Even $ 50 or $ 100 a month can help you pay more than the minimum on your cards and reduce your debt. (Use this calculator to see how it works.)

Benefits of a 401 (k) loan to pay off credit cards

If you’re considering a 401 (k) loan to pay off your credit cards, there’s a good chance you think your credit card debt has gotten out of hand. Wouldn’t it be great to bring those balances down to zero or at least to a manageable point? If you’re up to your neck in debt with your credit card, the benefits of borrowing from your pension plan seem pretty appealing:

–You will pay yourself interest, usually at a much lower rate than the interest rates on your credit card

Loan payments come out of your paycheck, so as long as you work for the same company, the reimbursement is automatic

–You are likely to pay the total balance sooner, since regular 401 (k) loans have a maximum term of five years and

–Your loan will be not be reported to the credit bureaus, so there is no effect on your credit score.

The high risks of using a 401 (k) loan to pay off other debts

Sounds too good to be true, right? Before starting this loan, make sure you know all the risks. There is a lot of:

–High taxes and penalties if you quit or lose your job as long as the loan is in progress. If you plan to quit your job during the loan term, it is usually best not to take out the loan. Most pension plans require that pension plan loans be repaid within a short period of time after an employee is no longer employed by the company. If you cannot repay it, the outstanding loan balance is reported to the IRS as an early retirement plan distribution and is taxable to you, plus an additional 10% penalty if you are under 59 1/2 . However, you may be able to save the situation by contributing the balance amount to an IRA rollover before you file your taxes for that tax year.

–You will lose growth if the market goes up. Think back to 2017, when the S&P 500 rose almost 19%. The power of capitalization increases as a profitable investment is held. You will be most successful if you contribute, invest wisely, and let the returns on your investments accumulate over a very long period of time.

–If you don’t radically change your cash management habits, you could again generate large credit card balances. Then you would have the 401 (k) loan and the new credit card balances to pay off. It could be a slippery slope. If you have access to financial coaching as part of your company’s workplace financial wellness program, be sure to take advantage of it. Working with a financial coach can help you better manage your cash flow so that the situation that prompted you to take out a retirement loan does not happen again.

You might be stuck with the 401 (k) loan even after bankruptcy. If you are not able to repay all of your debts with the loan and you need to file for bankruptcy, you will still need to repay your 401 (k) loan. Retirement plan loans are not discharged in bankruptcy.

It’s a last resort, not a first source of money

Before taking out a retirement loan to pay off credit cards, make sure that you have done absolutely everything you can to pay off your credit card debt and that you understand the significant risks involved. If you have access to a financial wellness program in your business, work with a financial coach to clearly assess your situation and weigh the pros and cons. Consider limiting yourself to just one loan and commit to keeping your cash flow under control so you don’t have to consider another.

When your 401 (k) loan is paid off

By the time you’ve paid off your retirement plan loan, you’ve probably gotten used to the loan payments from your paycheck. Now that you’re done, set up automatic deposits from your paycheck to a savings or money market account for the same amount. This way, you’ll build up emergency savings so you hopefully don’t have to rack up a credit card balance or take out a retirement plan loan again!

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