Some Consumers Look To Their 401(k) Funds For Debt Relief

At one time, consumers would have turned to the equity in their homes to help them out of a financial pinch. Today, that route has been closed for many borrowers who are no longer eligible for home equity lines of credit (HELOC), or whose existing HELOCs have been cut or withdrawn altogether. Fewer consumers – even those with good credit – are eligible for personal loans, and many consumers don't have sufficient savings to cover them in the event of an emergency.

These circumstances combine to make a 401(k) loan attractive to some consumers. On one hand, some financial advisors will say that when you borrow from your 401(k) plan, you're borrowing from yourself. The tactic is safe, they say, because you are repaying the loan with interest, so your retirement funds are still working even though you're putting them to use elsewhere. This explanation simplifies the rationale for borrowing from your retirement fund, but it doesn't do a good job of explaining the risks associated with such a loan. And the risks are plenty.

There are a few rules about borrowing from your 401(k) plan, but each plan may have additional borrowing rules. Typically, a loan from your 401(k) plan will be limited to 50% of your vested balance up to $50,000, depending upon your plan. Your plan will likely offer a low interest rate. Here's the catch: you could get a better interest rate and more stable loan terms by borrowing from a traditional lender, and your retirement funds have the potential of doing better in investments than with the low interest rate you'll pay on your loan.

Withdrawals from your 401(k) plan should be considered very carefully. Your ability to borrow from your employer-sponsored 401(k) plan is based on your employment. If you are fired or laid off from your job, you must repay any outstanding loans within 90 days of the date of separation. If you don't repay the loan, the loan will automatically convert to an ineligible withdrawal, and you'll be assessed income taxes on the amount of the loan plus a 10% penalty.

The risk here cannot be understated. If you're borrowing from your retirement funds, chances are good that you don't have the cash on hand to repay the loan. If you need to repay the loan in a hurry – as in the case of a job loss – you'll have a difficult time convincing a lender to refinance your retirement loan if you don't have a job. Further, your tax bill may become catastrophic (at a time when you really need your cash) if your 401(k) loan converts to an ineligible withdrawal, complete with taxes and penalties.

Some creditors may mislead you or may pressure you to withdraw retirement funds to pay your bills. Generally, retirement funds are protected in bankruptcy proceedings, so you should not consider them a ready source of cash to tap in a financial emergency. If your credit card debts or other obligations are causing you to consider a loan from your 401(k) funds, look for other options, including debt settlement to relieve the financial stress you may be experiencing.