Each option to obtain funds for unplanned expenses has its own pros and cons that are worth considering. We are going to explain the benefits and limitations of two common ways people get funds to pay off debt: take out a personal loan or borrowing from your 401k.
What is a 401(k)?
A 401(k) is an employer-sponsored retirement plan that allows you to invest a given portion of your salary into long-term investments. Companies that offer 401k plans generally offer different investment options, ranging from aggressive growth funds to conservative income funds.
If you are fortunate, your employer may even match a percentage of the contribution you make to your 401k. You heard that right – some employers will essentially give you “free” money for investing in a retirement plan. If you want to dig deeper, the International Revenue Service (IRS) provides detailed information about the different types of retirement plans.
Here is the takeaway: With a 401k, you sock away a small amount of your salary every paycheck over the duration of your career. This money builds interest over time, and when the time comes to retire, you can withdraw the money and live off your investment.
Should I Borrow From my 401(k)?
Borrowing from a 401(k) to pay off debt may seem like an attractive option, but it comes with a major tradeoff – a decreased retirement fund. In addition to having less savings in your retirement account to hold you over during your golden years, you could also be slammed with penalty fees for withdrawing from your 401(k) early.
According to the IRS, if you withdraw from your 401(k) before the age of 59 ½, you will be required to pay a 10% early withdrawal penalty in addition to income tax on the distribution. While it may be easy to borrow from your retirement fund, it is wise to consider the post-retirement implications borrowing from this source could cause.
Benefits of Choosing a 401(k) Loan to Borrow Money
APPLICATION REQUIREMENTS & INTEREST RATES
It could be said that 401(k) retirement plans have a leg up on personal loans when it comes to application requirements. Applying and getting approved for a personal loan with competitive interest rates requires that you have a decent credit score and credit history. While loan applications may be required for 401(k) loans, they are not subject to the same kind of underwriting as personal loans. Credit checks are not required, and while there are interest rates, they are generally much lower than those of a personal loan.
LOAN REPAYMENT OPTIONS
This could be a benefit or a detriment depending on your personal preference, but there are notable differences in how you repay a personal loan vs. a 401(k) loan.
When you apply for a personal loan, you generally get to select your loan term from a list of available terms. You also agree to fixed monthly payments to pay back the amount you borrowed. 401(k)s are different – you will generally have a total of 5 years to pay back your loan (though there are no prepayment penalties) and there are multiple options for repayment.
You can pay back a 401(k) loan by making monthly payments similar to a personal loan, or you can opt for payroll deductions to pay off your balance. With payroll deductions, a percentage of each of your paychecks will be skimmed off the top and put back into your 401(k) account. Depending on your situation and preferences, having funds automatically deducted from your paycheck could be an easier way to repay a loan.
Why not to Borrow from Your 401(k) Retirement Plan
While there are a few reasons that make borrowing from your 401(k) a good idea, this is something you should keep in mind:
Your 401(k) is not an emergency fund or a source of discretionary spending.
A retirement account is meant to support you through your golden years. When you find yourself faced with life’s unexpected expenses, a personal loan on the other hand could be exactly what you need to pay off debt and get back to focusing on your financial goals. Why jeopardize your retirement savings if you do not have to? If a personal loan can solve your needs, it is the better and less risky option.
Benefits of Choosing a Personal Loan
Personal loans may offer quick funds that can help you pay for life’s emergencies and make stressful situations more manageable. With a personal loan, you can borrow a fixed amount of money for a variety of reasons like debt consolidation, medical bills, or home improvement.
A major benefit of borrowing with a personal loan over a 401(k) is that you could receive the funds you need without paying withdrawal penalties. As we mentioned earlier, if you borrow from your 401(k) before you turn 59 ½, the funds you take out will be subjected to income tax and a 10% penalty fee.
As soon as you turn 59 ½ you can access this money without penalty. So this benefit may not play a huge role in your decision-making if you are of this age. With that said, it is a smart idea to consult a tax professional when making major decisions like this to ensure that you are doing what is best for your financial health.
SOURCE OF FUNDS
Another major benefit personal loans provide over 401(k)s is related to the source of the money you are borrowing. This is going to sound like common sense, but it is worth mentioning because it is one of the bigger downsides to borrowing from your 401(k): Retirement savings are there for you to keep for your future.
In a world where many people struggle to support themselves after retiring from the workforce, it can be a good call to preserve these funds at all costs. Taking out a personal loan, on the other hand, will not jeopardize the savings you have for retirement.
A notable pro that you may not have considered for personal loans is that they are timely. If a sudden, unexpected expense pops up, you could have the money you need within one to three business days.
According to Sapling, receiving the funds you withdraw from your 401(k) could take one to two weeks or even longer in some cases. If you find yourself in a situation where you need money fast, personal loans might be a better option.
401(K) FUNDS LOSE PROTECTION FROM BANKRUPTCY
Something you may be unaware of is the fact that the funds in your 401(k) are protected from bankruptcy. If you file for bankruptcy, federal law states that the money in your retirement plan cannot be touched by creditors and must remain in your name. However, the money you take out of your 401(k) is not protected in the same way. If you use a 401(k) loan to pay off debts and still remain in financial trouble, you have spent protected savings that could have been your safety net.
At the end of the day, it is a smarter financial decision to file for bankruptcy with your retirement savings safe in the bank than using those funds to pay down debts. Not only will you avoid spending the money you will need for tomorrow, but you will also have the added benefit of getting the most return from compounding interest on your investment.
Should you Take out a Personal Loan or Borrow from Your 401(k)?
There are a few reasons borrowing with a personal loan could be a smarter financial decision than borrowing from your 401(k), but everyone’s situation is unique. By closely considering the benefits and limitations of these borrowing options, you can ensure that you will be able to make the right call for your specific needs. We want to help you to decide, which financing option is best for you with a comparison of all the pros and cons:
|Taking out a Personal Loan
|• Obtain funding without incurring an early withdrawal penalty • Will not jeopardize retirement savings • Money could be in your account in as little as one day
|• Application necessary • Minimum credit score required • Could have high-interest rates depending on credit score
|Borrowing from a 401(k)
|• Generally simpler application process • No credit check required • Typically lower interest rates
|• Funds withdrawn from 401(k) lose protection from bankruptcy • Penalty fees and taxes for withdrawing early • Generally it takes one to two weeks to receive funds
This article is for educational purposes only and is not intended to provide financial, tax or legal advice. You should consult a professional for specific advice. Best Egg is not responsible for the information contained in third-party sites cited or hyperlinked in this article. Best Egg is not responsible for, and does not provide or endorse third party products, services or other third-party content.