401k Loan to Pay Off Debt: Read the Exit Rules First

Would you borrow from your own 401(k) to wipe out your credit cards?

Derek did the math and loved it. He's 41, owes $14,200 across three cards at about 24%, and his coworker says to borrow from his 401(k) instead. Derek asked me if that was crazy.

It's not crazy. The math is solid. That's what makes it dangerous.

Why It Looks Like a No-Brainer

Those cards cost Derek roughly $3,400 a year in interest. His $430 in monthly minimums barely dents the balances, so he's paying a lot to stand still.

He has $96,000 in his 401(k), and his plan lets him borrow up to half. Say the plan charges 8%. That's a third of what the cards charge, and the interest goes back into his own account instead of the bank's.

If nothing changes, Derek wins.

Your Job Is the Collateral

Something always changes.

If you quit, get fired, or get laid off, the plan can call the loan. In my experience, 60 days is the window I hear about most, and plans vary, so read yours.

Think about the timing. Your paycheck just stopped, and the money you borrowed is long gone because it went to the cards.

So the plan treats the unpaid balance as money you took out. That means income tax on it, plus a 10% early withdrawal penalty if you're under 59½.

Say Derek still owes $18,359 when the layoff hits. In the 22% bracket, with the penalty, the federal bill is about $5,875, before any state tax.

Compare that to the $3,400 a year the cards were costing him. The "cheap" loan just handed him a bigger bill than the interest he was trying to avoid.

There Is a Back Door

Roll it over.

When the loan comes due because you left your job, the IRS gives you until your tax return due date, including extensions, to roll the unpaid amount into an IRA. Roll over the full amount and you skip the income tax and the 10% penalty on it.

The catch to the catch is the cash. You still have to find the money to make that rollover, and that's hard the month you lost your paycheck.

Two Quiet Costs

Your paycheck gets smaller, because the loan payment comes out automatically.

The money also sits outside the market while you pay it back, so it stops growing.

If you already know layoffs are coming at work, or you're thinking about leaving, skip the 401(k) loan. Call your card company instead and ask for a lower rate. There's no harm in asking.

I can't tell you what to do without seeing your whole picture, so treat this as a list of questions to answer first.

Three Numbers to Write Down

1. What the cards cost you in a year

Multiply the balance by the rate. For $14,200 at 24%, that's about $3,400.

2. What the loan payment does to your paycheck

Ask your plan for the payment amount, then run it against your monthly budget.

3. Your plan's payoff window if you leave

Check your plan documents or call the plan administrator. Write down the number of days.

Start With the Numbers, Not the Shame

Get the numbers.

Read the plan's exit rules.

Then make the call.

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