If you are reading this, it’s likely you are considering withdrawing funds from your retirement account. While it may seem like a good plan (after all, it is your money anyway), it’s rarely a smart idea to borrow from your 401(k) plan.
Before you make the decision, let’s first explore what may be causing you to consider it. Finally, perhaps I can persuade you NOT to do it.
What does it mean to borrow against your 401(k)?
I am not going into any details here. The short and simple answer is that you are loaning the money to yourself. You repay the loan including interest over a set period of time. The IRS sets limits as to how much of your balance you can withdraw as well as guidelines for the interest rate. You can obtain the details from your plan administrator.
Reasons why you should not borrow
Borrowing against your 401(k) plan may seem harmless since you are paying yourself back along with interest. This is the argument that everyone seems to use.
However, you will be missing out on the opportunity cost. Which in simple terms means the funds you are borrowing are not going to grow or increase. In addition, it is likely that you will either reduce your current savings rate or stop contributing towards your retirement during the time are you repaying the loan. This all means you will have less money for your retirement.
Most common reason to borrow from your 401(k) plan
The most common reason is to pay off credit card debt. It appears to be an easy way to address your consumer debt. It is likely that your monthly minimum payments are too high to pay month after month. Depending upon your particular situation, it may make sense to use the funds to pay off the debt. However, I have never offered it as a solution when I work with clients. Mainly for the reasons outlined above.
There are two important factors in paying off your credit card debt. The first is deciding how you will pay it off. The second is to understand why you have accumulated credit card debt. Both can be challenging.
Borrowing against your 401(k) can be a short-term solution to eliminate your outstanding consumer debt. However, I generally do not believe it is in your best interest for the long-term to do so. Often times, paying off debt can be addressed by cutting back on expenses and or earning extra income. In some cases, you may be able to borrow from a friend or family member.
Why you have accumulated debt is typically lifestyle creep. Meaning you have slowly added to your debt. As your income has risen, you have added expenses that you believe you can afford. Before you realize it you are spending more than you are earning. Both steps can be difficult to self-diagnose and you may want to seek professional help.
Final Thoughts
Before you dip into your retirement funds to pay off consumer debt, take your time to consider the alternatives. While there may be good reasons to borrow from your 401(k), the reasons are extremely rare. The question to answer first is whether you have other choices before making this step.