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Ask Dr. Don

Borrowing from retirement account

Dear Dr. Don,
We have a great deal of credit card debt, and we are able to borrow from my husband's retirement to pay some of it off. The loan will only be for five years and will be repaid through a payroll deduction. Is this a wise thing to do?

Dear Terri,
Yours is a classic dilemma. You're saving for retirement, but not living within your means. Now you want to pay off your current debt by tapping your retirement savings.

If your credit cards have an average rate of 17 percent and the loan from your retirement plan is at 8 percent, then it seems an easy decision to borrow from your retirement plan to pay off this debt. The chart below will help you frame the decision given the particulars of your situation.

In most 401(k) plans you can borrow up to 50 percent of your vested balance, but not more than $50,000. You have to pay the money back with interest over five years, longer if the loan is for a principal residence.

The good news is that the interest payments are going into your retirement account and not to the credit card company. The downside is that the original contributions to the account were made with pretax dollars, but the loan payments will be made with after-tax dollars.

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If you're in the 31 percent marginal federal income tax bracket, it will take $1.45 in wages or salary to replace each dollar you borrowed from the account -- plus interest. The interest payments aren't tax deductible and will be considered as earnings in the account. When you take qualified distributions in retirement, you'll pay income tax on the distributions including the interest expense you paid on the loan.

If you don't repay the loan, you will owe both the income tax and a 10 percent penalty tax on the early distribution. If your husband's 401(k) plan is like most plans, the loan will become due immediately if he leaves the company.

I've taken a hypothetical situation to show the savings associated with using the 401(k) loan at 8 percent and comparing it to paying off a credit card balance at 17 percent.

You can put together your own table by using Bankrate's Loan Payment Calculator to calculate the monthly payments and the Simple Savings Calculator to determine the value of the loan payments reinvested over the next five years vs. how the account would grow if you didn't withdraw money to pay off your credit cards.

401(k) loan vs. credit card repayment comparison
401(k) loan at 8%
Credit card at 17%
Loan amount
Monthly loan payment
Total payments
(monthly payment x 60 months)
Interest expense
(Total payments -- loan amount)
401(k) loan payments reinvested @ 10% APR for 5 year
$25,000 remains in 401(k) earning 10% APR for 5 years

In this case it makes sense to borrow from the 401(k). You've saved almost $7,000 in interest expense and you've freed up $115 in your monthly budget that you could use to pay back the loan faster. Put in your own numbers to make the worksheet relevant to you.

The three big concerns to avoid are: You take this as an opportunity to run up your credit card balances again; you stop making any contributions to your retirement accounts other than the loan payment; your husband leaves the company and is forced to pay the loan in full within 90 days of leaving the firm.

Putting money aside for the future requires that you spend less than you make. If you're not doing that, you need to get to the point where you are. If you're spending like there's no tomorrow, then don't be surprised if tomorrow comes and you don't have any money to spend.

-- Posted: Nov. 6, 2001

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See Also
Penalty-free IRA withdrawals
Retiring early on your 401(k)/IRA without penalty
Should you use 401(k) money to buy a house?


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