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Become debt free using 401k

Sun Sep 24, 2006 10:09PM | By Tony

See more in Debt Relief | Permalink | Email | Comments (1)

You can become debt free by borrowing from your 401k if your plan allows this. This debt relief path have to be thought thoroughly but you can't simply listen to those who flatly tell you that this is a no-no thing. Consider these factors:

1. How deep you are in debt and how much you want to break free is very important consideration. If your debt is somewhat tolerable in terms of monthly payments and interest rate, or if you have other means, f.e. your home equity to become debt free, you should think twice about using 401k for debt relief.

2. If you intend to quit your present job, you must know that you will have to repay your 401k loan pretty much immediately or face 10% early withdrawal penalty plus pay regular taxes. Note that this will still make sense if your 10% penalty is less than the amount of interest you have to pay to keep your debt payment up to date.

3. Other important things to know: you must repay money back to your 401k in less than five years. One exception is that loans for a primary residence can be repaid over 30 years. So here is the workaround - borrow money for your home and then borrow against home equity. A clean way to become debt free with help of 401k.

Don't read too much into the statements such as "you are giving up the tax-free compounding of the money you withdraw. That could lead to a significantly smaller nest egg come retirement." or "consider how much you will lose on the withdrawal assuming 10% interest a year accumulated tax-free for 15 year". Assuming is the key word, as I saw too many quite depleted 401k saving plans during stock market turmoil of 2000, 2001 and 2003 years, so 10% a year is a stretch as most people I know put their money into money markets barely earning 3%. You debt is very real, no assumptions here, and to break free from this debt you have to make some tough choices.

Another silly argument can be found in statements and not-to-do things of many financial gurus who divide everything on black and white - "Don't borrow from your 401k, it's a horrible deal - your 401k contributions are pre-tax and will get taxed later on, when you withdraw the money from the plan. But if you take out a loan, you're pulling out pre-tax dollars that you will then have to repay - with money that has already been taxed. Then when you eventually retire the money is going to be taxed again, so your loan gets taxed twice."
This notion doesn't make any sense, you are using your pre-tax dollars to become debt free, in essence you pay off your debt interest-free with tax-free money. Yes, you have to pay back from your after-tax paycheck but you are paying to yourself. The other thing is what will be your tax bracket when you retire? Chances are it will be lower than now while you are earning full time income.

Here four advantages of using 401k loan to get debt relief:

1. You can get the loan within a week or so of applying to your company
2. No credit approval needed - you are borrowing your own money
3. Interest rate is low - at prime rate or slightly over, around 6% today and you pay it back to yourself
4. You can borrow up to $50,000 or 50% of your 401k balance, whichever is smaller

As we always say, use your brain - the only way to gain and become debt free.

Comments

I am 30k in credit card debt with 52k in my 401k and no job. I need to get out of debt. There are not jobs in Michigan right now and paying off the credit cards could really help. Can someone walk me through?

Posted by: Shari Flockhart | April 4, 2007 10:52 PM

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