Should You Borrow from Your 401k Plan to Settle Credit Card Debt?

27 May Should You Borrow from Your 401k Plan to Settle Credit Card Debt?

A client asked me recently whether he should borrow from his 401k plan to settle his credit card debts, or file bankruptcy. Like many such questions, the answer depends on circumstances, but these are some factors to consider:

  • The number and type of debts outstanding. My client has six credit cards, we have been able to settle three of them, and they are the largest three. If, however, we cannot reach an agreement with the other three, the amount of “leftover” debt may still be enough to require bankruptcy. If that is the case, the debtor has effectively wasted his 401k money. If you only owe a few debts, it is more reasonable to expect to settle all of them. The more you have, the less likely you are to be able to settle with everyone. Be sure you don’t dissipate your retirment savings only to end up right where you started.
  • How much are the payments on your 401k loan going to reduce your paycheck? This will depend to some extent on how much you borrow, but every plan is different. Before you borrow from the plan, you need to know how it will affect your budget. Approach this question just as you would consider whether to re-finance your home to settle credit card debt. If the 401k loan is going to leave your budget so short that you can’t make your mortgage payments (or any other obligation), you are probably going to be better served by a bankruptcy.
  • How close are you to retirement, and how much are you going to deplete your retirment savings? Again, this will depend to some extent on how much you are thinking of borrowing, but you should consider how long it will take you to repay the 401k loan, and the loss of growth in your plan in the meantime. If doing so will delay your retirement, or if there are other reasons to doubt your ability to rebuild, it may not be the best idea.
  • How secure do you feel with your job? If you take a loan against your 401k plan, and are then laid off or decide to quit, you may have to convert that loan to a distribution, which will trigger taxes and penalties.

Remember, when you borrow from your 401k plan to pay credit card debt, you are paying creditors with funds that they would not be able to reach otherwise, and in a way that may have adverse tax consequences for you. There may be times that it is a good idea, but be sure you are getting what you need, and that you don’t pay a higher price than you intend.

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