Excessive credit card debt is never good. If you are thinking about paying off your credit card debt using a 401(k) loan, there are some things to consider first.
What is a 401(k) Loan?
With a 401(k) loan, you borrow money from your 401(k) retirement account. As with any loan, there are both advantages and disadvantages to it. If you use the borrowed money to pay off your credit card debt and your payments are on time, you could save money in the end, but there are still a few negative considerations to take into account.
Pros of Using a 401(k) Loan to Pay Off Credit Card Debt
Paying off your credit card debt using 401(k) loans has some definite advantages.
Lower Interest Rate
Even if you have one of the best credit cards offered, you could be paying more interest than you would with a 401(k) loan. The interest on credit cards and 401(k) loans are based on the prime rate. However, the interest on credit cards is usually 10 percent or more above that rate, the interest rate on a 401(k) loan is only one to two percentage points higher.
Interest Paid to You
With a 401(k) loan, the interest paid goes back to you. Usually, an employer deducts from the borrower’s paycheck each month, redepositing both the loan principal and interest back into your 401(k) account. This helps offset any gains that you might have missed while the borrowed money was not in the account. With this in mind, 401(k) loans are seen as a low-cost loan when used correctly.
No Credit Effect
To pay off credit card debt with a 401(k) loan has no adverse effect on your credit. While a personal loan gets reported to the major credit bureaus which can cause your score to drop 5 to 10 points, a 401(k) loan does not. A 401(k) loan is not a “loan” per se. Instead, you have permission to access the balance in your account without paying taxes or being penalized. Adversely, there is also no opportunity to build credit, but at least there isn’t a negative credit mark to worry about.
Cons of Using a 401(k) Loan to Pay Off Credit Card Debt
Even though there are advantages to paying off your credit card debt with 401(k) loans, there are a few drawbacks as well.
While the Internal Revenue Service permits employers to offer 401(k) loans, not all do. Also, depending on the plan, the terms may be more restrictive than what you feel comfortable with, and there is a cap as to how much money you can borrow. For a 401(k) loan, you can only borrow up to 50 percent of the vested amount or $50,000, whichever amount is less.
Another disadvantage is that, according to IRS rules, you have to repay the borrowed amount within a five-year period or less if mandated by your employer. If you fail to pay the loan on time, the outstanding balance is considered a distribution.
As for taxes, if you quit your job and no longer have a 401(k), then you would no longer have tax-sheltered status. In the event that you lose your job and 401(k), you have a 90-day period to pay off the full balance before it becomes taxable. However, in general, if you are employed with a 401(k), then you are not required to report loan amounts as income for taxation.
Author: Jeff Gitlen
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