Paying Your Taxes: Should You Use a 401k Loan to Pay Off Debt?

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Over 8 million Americans owe back taxes to the IRS.

We understand that falling behind on your taxes is incredibly stressful, especially when you have other expenses that you feel are more of a priority.

However, a failure to address your tax debt carries serious consequences. In addition to a failure-to-pay penalty of 0.5% of the total amount owed every month you fail to pay, you will also likely miss out on a potential refund. 

If you’re especially delinquent, you’ll be hit with even more fees and the possibility of property seizure, a tax lien, and more. 

Should you use a 401k loan to pay off debt on back taxes? 

You don’t want to face any of the aforementioned consequences, but you simply don’t have the money to pay your overdue tax bill. 

In this post, we’ll go over the process of taking a loan from a 401k to pay off debt. By the end, you’ll be able to better evaluate whether or not it’s the right move for you.

What Is a 401k Loan?

We know that the thought of borrowing from your 401k can make you feel anxious.

After all, that money is meant to be used to help you in your retirement.

While borrowing from your 401k to finance your dream wedding or buy a home that you truly can’t afford is never a smart move, borrowing from it to pay your back taxes is one of the rare times when tapping into your 401k plan can be acceptable. 

It’s important to understand that 401k loans aren’t “loans” in the traditional sense. 

Instead, the only real person that you’re borrowing money from is yourself, and you won’t need to get approval from a lender to get the money. 

While every employer has slightly different rules regarding early access to 401ks, in general, you’re allowed to borrow the lesser value of either 50% of your 401k plan or $50,000. 

Another common question is, “Do I have to pay taxes on a 401k loan?” The answer is no, which is another reason why using a 401k to pay off debt from back taxes is a good move for some.

In addition to not having to pay taxes, the interest charged on your 401k loan actually goes back into your 401k account. Basically, you’ll end up moving that money from one account to another. 

Especially if you know you can’t afford to pay the high-interest rates on a credit card or another type of loan, borrowing from your 401k may be a smart move. 

As of this writing, about 1/3 of Americans say that they have borrowed from their retirement savings in some way. 

More Pros of a 401k Loan

In addition to not being charged taxes and high-interest rates when taking a loan from a 401k to pay off debt, there are a few other reasons why it may be a smart idea.

The process of getting the money in your pocket (and to the IRS) is much faster and easier than the often lengthy process of applying for a traditional loan. In most cases, you won’t even need to undergo a credit check in order to access funds from your 401k. 

Plus, when you take out the loan, you can rest easy knowing that your credit score won’t be negatively affected. 

In most cases, you’ll have five years to pay back your 401k loan, which is a much longer repayment period than other types of bank or third-party lender loans. Usually, when you borrow from your 401k, there is no penalty for early repayment. 

You’ll be able to enjoy a bit of repayment flexibility here, as well. You can even set up automatic payroll deductions so that you can pay back the money you borrowed without a second thought. (Be aware, however, that those payroll deductions are made with post-tax dollars.)

Plus, the interest rate (which again, you pay to yourself) on a 401k loan is only about 4-5%. Credit cards generally carry an interest rate of 15% or higher–meaning that it’s easier than ever to get trapped into an endless cycle of debt. 

Finally, you’ll be able to avoid those hefty loan initiation fees that you often get hit with when you borrow from a traditional lender or bank. 

However, paying taxes on 401k plans do have some drawbacks you need to consider. 

Let’s take a closer look at the reasons you may want to look into other options below. 

The Cons of Borrowing From Your 401K

Up until now, using a 401k loan to pay off debt you owe to the IRS must seem like a pretty great deal. 

You don’t really pay interest, you can avoid a credit check, and you’ll be able to access the money incredibly quickly. 

As with any type of loan, however, there are a few reasons why this might not be the right move for you.

First of all, whenever you borrow from your retirement savings, you’re putting your financial future at risk. This is especially true given that when you pay back what you’ve borrowed, you must repay it with after-tax funds.

If you’re in a 20% tax bracket, for example, every dollar you put towards repaying a 401k loan is actually only 80 cents. It’s easy to see how over time, this could chip away at your retirement savings in a pretty significant way. 

Additionally, depending on employer regulations, you may not be allowed to continue to make contributions to your 401k until you’ve completely repaid your loan. This is, perhaps, the biggest reason to look into other avenues of paying back your taxes. 

Remember too that you’re also missing out on the opportunity for the money you took from your 401k account to earn any kind of investment returns. 

Plus, you need to consider the unfortunate reality of an even greater potential financial hardship. What if you become ill and are faced with high medical bills? What if your home is hit by a natural disaster? 

If you default on your loan, the rest of your balance will be taxed at your current rate. And if you’re under the age of 59.5? 

You’ll be hit with another 10% early withdrawal fee. 

You also need to consider what could happen if you lose your job. Let’s discuss that now. 

401k Loans and Job Loss

Even if you feel completely secure in your job now, the reality is that there are so many situations–including a potential minimum wage hike–that could cause you to be let go. 

While the sudden loss of a job (or the decision to quit) is a financial disaster for many, that loss will hit doubly hard if you’re using a 401k to pay off debt. 

Why? 

Because you’ll have much less time to repay your loan, and you must repay the full outstanding balance from your 401k loan. That new repayment timeline begins on the day your next federal tax return is due (with a minimum of 60 days after you’ve left or lost your job).

Additionally, think about the fact that you’re essentially limiting your career options when borrowing from your 401k. 

If you leave your job, you’ll be faced with undue financial hardship because of the loan. This means that you will have to stay in a dead-end job or even turn down better opportunities for up to five years. 

Is it really worth it? 

If you feel confident in your ability to stick with your job and repay the loan early or at least on-time, then maybe the answer is “yes.” However, we do suggest that, before you commit to going the 401k loan route, you look into other options first. 

Learn more about a few of the other ways you can pay back taxes owed to the IRS below. 

Alternatives to Using a 401k Loan to Pay Off Debt

Nervous about taking out a 401k loan? 

We understand why. 

The good news is that it’s far from your only option when you owe money to the IRS.

While no one likes the idea of borrowing money just to fork it over to the IRS, the following options may be a smarter financial solution for you. 

Look Into IRS Payment Installment Agreements

In most cases, your best bet will be to set up an installment agreement plan with the IRS. 

This offers the most flexibility and takes your current financial situation into account. 

You and the IRS will come to an agreement about how much you’re able to pay on your taxes now, the total amount of taxes you owe, and how long it will likely take you to repay those taxes. 

You’ll have to pay an application fee of $149 to get an installment agreement, however. You’ll also be charged interest on the short-term federal rate, plus another 3% interest. 

If you fail to pay, the IRS can and likely will terminate the agreement. 

Click here to get the form you need to apply.

Consider a Hardship Extension  

Even the IRS understands that sometimes, you’re facing such a financial hardship that you’re simply unable to pay your taxes at this time–you need your tax money to survive. 

In this case, you should likely apply for a hardship extension with the IRS.

Of course, you’ll have to prove to the IRS that financial hardship does currently exist, and this process can sometimes take longer than you’d like. 

As of this writing, it is free to apply for a hardship extension. 

However, you will be charged 3% interest on top of the short-term federal interest rate when applying for a hardship extension. 

Apply for a Short-Term Extension

If you know you could repay the past due balance on your taxes if you just had a little bit more time, consider applying for a short-term tax extension. 

In most cases, you’ll be given a 120-day extension on your taxes–but you must repay the balance in full.

While there isn’t a fee to file for a short-term extension, you will be hit with a 0.5% monthly fee if you fail to make the payment in full. 

Taking Out a Personal Loan

Often, taking out a personal loan to pay back your taxes is much cheaper than the interest rate charged on a credit card. 

However, it’s still a pretty pricey move. 

We suggest comparing interest rates–and negotiating with–multiple lenders, and borrowing as little money as you possibly can.

As with a 401k loan, you need to be certain that you’ll be able to pay back what you owe within the loan term. 

If you can’t, you’ll be in even more financial trouble than you were to begin with.

Looking for More Tax Advice? 

We hope that this post has helped you to be able to make a sound decision about whether or not using a 401k loan to pay off debts to the IRS is the right move for you. 

If it’s not your best option, consider speaking with a tax or financial professional to help you better understand the other options we’ve discussed here. 

No one enjoys dealing with the burden of back taxes, taking money from their retirement funds, and dealing with high-interest rates on loans. However, the inability to repay your taxes on time is just one of the many issues with your tax return that you could face. 

Are you in need of actionable tax advice that will save you time, stress, and most of all, money? 

We can help. 

Reach out to us today for a free tax evaluation, and don’t face the IRS on your own. 

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