Borrowing Against Your 401k, The Right Way

Last week I was asked the following question:

“My boyfriend has around $7,000 in credit card debt at 18% interest. He wants to know if borrowing from his 401k to pay this money back is a good idea. I said no, that he should just start putting all his spare cash into paying down the debt. What do you think?”

I tend to think of money that you have saved for retirement as untouchable. Personally, I would exhaust lots of other potential sources of money before thinking about tapping into my 401k. But there are two exceptions.

One is if you have already saved enough money for retirement. If you are in your 40s and have $2 million in your 401k, then borrowing some of that money may make sense in some situations.

The burden of high-interest debt…

However, the other circumstance is the one described by the question above. One of my most important personal finance rules is to avoid high-interest debt at all costs. I highlighted this in 7 Steps For (Nearly) Effortless Wealth-Building. On this topic, I wrote:

“Over the past 90 years, the average annual return of the S&P 500 is 9.8%. The S&P 500 is a stock market index that contains the 500 largest companies trading on stock exchanges in the U.S. You can invest directly in a mutual fund (a fund that pools money from many investors) which aims to replicate the S&P 500.

However, before directing money into such a fund, you need to identify and eliminate any debt with an interest rate above about 7%. The reason for this is that if you are earning 9.8% in the stock market, but you are separately paying debt with an interest rate of 7%, you are doing so with after tax dollars so it is equivalent to 8%-10% returns in reality.

You really aren’t gaining ground. What you earn in the market is being lost to interest payments. And if the interest rates are higher than this, you are really losing ground. Find savings in your budget and pay off those parasitic high-interest debts.”

Credit card debt at 18% interest is a high priority for elimination. If you borrow from your 401K to eliminate this debt, you pay yourself back with interest.

However (and I can’t stress this strongly enough) you must pay the money back. If you do not, and you aren’t at retirement age, it will be treated as an early distribution from your 401k. You will get hit with a 10% penalty, and then you will have to pay income taxes on the distribution.

Further, if you don’t pay it back you will no longer benefit from the tax-deferred accrual in the account. Thus, if you think there is any possibility that you will be unable to pay it back, then don’t go down this route. Just do everything you can to get that high-interest debt eliminated.

Otherwise, I would endorse tapping your 401k to get rid of high-interest debt, but I would also recommend you pay yourself back as quickly as possible.

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