Financial gurus have written a lot about the pros and cons of 401(k) loans. It’s still a hotly-debated topic. One of the biggest potential drawbacks comes into play if you leave your job while you still have an outstanding loan from your 401(k) plan. So today, let’s take a look at what happens when you pull money from your 401(k) and whether you should borrow elsewhere to return the funds to your retirement account.
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Leaving a Job With an Outstanding Loan
While many financial advisors would recommend (with a passion) that you never borrow money from your retirement plan, the fact is that it happens. Sometimes, an opportunity may present itself that warrants the 401(k) loan. Other times, you may make the choice out of sheer necessity. After all, a 401(k) loan is typically smarter than other “quick cash” options like payday loans.
If you’re considering a loan, know that you’re not alone. In fact, according to a 2014 study by the Employee Benefits Research Institute, 21 percent of employees who were eligible for a 401(k) loan had one outstanding. With so many people owing money back to their retirement plans, though, there’s the potential for an issue.
The biggest problem, as mentioned, is when you leave your job and haven’t paid the loan back in full. This may be because a better opportunity presents itself and you choose to change jobs. Or it might be because you are laid off or fired.
When this happens, you generally have two options: (1) pay back the loan in full within 60 days, or (2) …don’t.
If you follow option two, just know that the IRS will treat the loan as an early withdrawal from your 401(k) plan. With very few exceptions, they will then smack you with a 10% penalty on the outstanding loan amount and also require you to pay taxes on the distribution. Thus, you could easily end up paying 30% or 40% of the outstanding loan amount in penalties and taxes.
It goes without saying that failing to pay back the loan within the allotted time period can be a very costly decision.
How to Pay It Back Quickly
The problem that often arises is that folks want to pay back the 401(k) loan within the 60-day window. But they simply can’t afford to do so. This is particularly true in difficult economic times or when someone is unexpectedly let go from their job without time to financially prepare. In either case, borrowers often lack the available funds to repay the loan in the 60-day period.
That leads us to an important question: Should you borrow to repay a 401(k) loan?
The short answer, in my opinion, is absolutely yes. And to my surprise, it’s also Dave Ramsey’s advice. And we all know how much he preaches against non-mortgage debt.
It may seem a little like borrowing from Peter to pay Paul, but it has its merits. With the taxes and penalties you’ll owe if you don’t repay the 401(k) loan right away, the cost will almost always be greater than the cost of a short-term personal loan at reasonable rates. In addition, by not repaying the 401(k) loan, you will forever remove that money from your retirement investments. Thus you’ll lose the tax-deferred return on your 401(k) investments forever.
Where to Borrow
Of course, one big question still remains. Where should you look to borrow money to repay a 401(k) loan?
Here are a few places to look if you need to quickly return borrowed funds to your retirement account before being hit with fines and penalties:
- Home Equity Line of Credit (HELOC): Perhaps the first option would be to tap into a home equity line of credit. Equity lines generally come with reasonable interest rates and are easy to access if you have some equity built up in your home.
- 0% Balance Transfer cards: Another potential option is to take advantage of one or more 0% balance transfer offers. Before going this route, however, make sure you can pay off a 401(k) loan balance with the balance transfer card(s). Depending on how much you borrowed, you may still come up short. Also keep in mind that the introductory rate periods are frequently as low as six months. After that, the interest rates adjust to whatever regular APR applies to the card. That can be as high as 20-30 percent! This option is best if you can repay the money transferred well before the introductory APR expires.
- LendingClub: A popular peer-to-peer lending source, LendingClub offers unsecured loans up to $25,000. Depending on your credit history, credit score, and other factors, you can obtain a loan at a reasonable interest rate. All loans must be repaid over three years, although you can choose to pay off the loan sooner.
- Unsecured Line of Credit: You can obtain unsecured lines of credit from most banks and credit unions. Interest rates will vary significantly based on your credit history. I have an unsecured line at Citibank that I rarely use, but it does come in handy for short-term loan needs.
So, what’s your take? Should you borrow to repay a 401(k) loan if you don’t have the funds available to repay the debt?