An individual who uses their 401k to pay off debt can incur more debt. Typically, the idea of using a portion of the 401k for debt relief is alluring. For instance, someone can borrow money from their 401k retirement account and repay within a specific amount of time such as five years of the date of the withdrawal. What sounds better is that the person is paying the interest on the amount back to themselves instead of a loan company. However, borrowing money from a 401k means paying taxes on the amount and having a penalty assessed if the individual is under the age of 59 and ½. The penalty exists because the purpose for retirement plans is to use them for retirement and not for debt relief, according to Bankrate.
Potential Problem: 401K Account Repayment is Accelerated
If at any time an individual leaves their job voluntarily or because of termination, the employer can request the borrowed funds be repaid immediately. For instance, the person may have to repay the money three months after they leave. This means that the debt relief is temporarily and the person is back in debt for the same amount—or more.
Possible Alternative to Borrowing from 401k Account
An individual steep in credit card debt can try some lifestyle changes. For instance, stop using all credit cards. Although this may be tough at first, using cash instead of credit will ensure that the credit card debt doesn’t jump higher. Another option is cutting out all unnecessary spending and pay the money to the credit card companies.
Personal bankruptcy is the debt management of last resort. However, for anyone overwhelmed with credit card debt and unable to repay, it may be an option to consider. Chapter 13 bankruptcy is for people with enough income to repay creditors. Similar to taking money out of a 401k, the money can be repaid within a certain time period. For instance, a person may make monthly payments for three to five years. Another bankruptcy option, chapter 7, is for a person without regular income or not enough to repay the debt. Under chapter 7 the person’s debts—including credit card debts—are eliminated without repayment.
Seek Legal Help before Borrowing from 401k Account
According to SmartMoney, before anyone considers tapping into their 401k, they should make sure that all other nonretirement options are exhausted. An attorney can help anyone behind in their credit card debt and trying to manage it.