How to Use Your 401k to Pay Off Debt
9 MIN READ
Published August 23, 2023 | Updated September 25, 2023
Using your 401k to pay off your debts early may take the pressure off you quickly. But it’s important to understand the consequences before you decide if it’s the right option for you. Additionally, there are several different ways you can withdraw money from your retirement fund, so it’s crucial for you to learn more about each of them and compare their pros and cons.
Is Using 401k to Pay Off Debt Right for You?
Before using 401k to pay debt early, consider the pros and cons of doing so.
- You’ll be able to pay off your debt sooner. When you withdraw from your 401k, you may have enough saved to pay off your credit card debt or other debts in full.
- Once you get out of debt, you’ll free up your budget. You can contribute this extra money toward savings.
- If debt is causing you financial stress, you’ll find some relief once you pay it off.
- If you are taking out a 401k loan, you’ll usually get it at a lower interest rate than what you may be paying on your credit card or other debts.
- Your credit report or credit score will not matter because the plan administrator will not check it to determine if you can borrow funds, and you’ll have easy access to funds.
- You may have to pay a high tax bill on your withdrawal. Your 401k is gross income and is taxed when you withdraw.
- There’s a 10% penalty on withdrawals to discourage people from withdrawing funds from their 401k.
- You’d lose the money you may have earned in interest if you’d kept the money in the account.
- You may lower your retirement fund, and this may push back your retirement date.
How to Use 401k to Pay Off Debt Safely
There are only a few circumstances in which you may be able to withdraw from your 401k without incurring the 10% penalty. You’ll still be liable to pay taxes on withdrawals:
If using 401k to pay off debts is your only option, here are a few things you can do to lower your risk:
- If you are taking out a 401k loan to pay off your debts, stop using your credit cards. Making loan payments each month, along with credit card payments, will only make things worse for you because it will increase your debt load and make repayment more expensive.
- Don’t borrow more than you need. Make a budget to determine how much you’ll be able to pay each month towards the 401k loan. If you are simply making a withdrawal from your account, withdraw the lowest possible amount.
- Continue to contribute to your 401k regularly, at least enough to ensure you’re getting your employer’s match. This will minimize your financial risk.
Know the Rules and Regulations
The rules and regulations on withdrawals from your 401k plan will depend on the type of 401k you have as well as your age.
If you are withdrawing before age 59 ½:
In case of an early withdrawal, you’ll be subject to a 10% withdrawal penalty and income tax. There may be some exceptions to the penalty, such as if you are paying tax debt to the IRS.
If you are withdrawing after age 59 ½:
You won’t have to pay the 10% early withdrawal penalty once you reach the age of 59 ½. However, you’ll still need to pay taxes if you have a traditional 401k. Your withdrawals may be tax-free if it’s a designated Roth 401k and if it’s at least five years old.
Calculate the Impact on Your Retirement Savings
Using your 401k to pay off debts can deprive you of the benefits you would get through investment growth in the long term. The longer you keep the money in your account, the higher the potential gains. This loss, along with the fees, penalties, and taxes, can add up quickly.
For example, if you are withdrawing $50,000 from your 401k before turning 59 ½, you’ll have to pay a 10% ($5,000) withdrawal penalty. Additionally, you’ll also pay income tax on $50,000. If your federal tax rate is 24% and your state tax rate is 5%, you’ll also be paying $14,500 in taxes. That means that if you withdraw $50,000, you’ll only be getting about $30,500 on hand after penalties and taxes. You can use an online retirement plan withdrawal calculator to determine how much it will cost you if you decide to withdraw early.
Using an investment calculator, you can also determine the future value of your investment. For example, if you had kept $50,000 in your account at an investment return rate of 5%, the future value of $50,000 could be $169,000 in 25 years.
Consider Other Options for Paying Off Debt
Your 401k isn’t the only or the first place you should look when it comes to getting out of debt. There are several great alternatives you should explore before you consider withdrawing from your 401k. If you have debts from multiple sources, consider taking out a debt consolidation loan to roll all your debts into one. With a lower interest rate loan, you’ll be able to save a considerable amount of money in interest charges. You can also opt for a balance transfer credit card if you primarily have credit card debt.
If you have a lot of unsecured debt, debt settlement is another option. This involves negotiating with your lenders to settle your account for less than you owe in exchange for a lump sum payment.
In some cases, you may simply need to take a closer look at your budget to evaluate how much you’re earning vs. how much you’re spending. You can opt for credit counseling to learn more about budgeting and money management techniques to figure out how to reduce your spending and free up money to pay off your debts.
Using 401k Hardship Withdrawal to Pay Off Debt
An alternative method of using your 401k to pay off debts is through hardship withdrawals. If you’re facing financial hardship, you may be able to withdraw funds without having to pay the associated fees.
What is a Hardship Withdrawal?
A hardship withdrawal is withdrawing money from your 401k account for immediate and heavy financial needs. Since this is an authorized withdrawal, the IRS may waive penalties, but you’ll still have to pay taxes.
Before using 401k hardship withdrawals to pay off debt, you’ll have to make sure you are eligible for it. You may be eligible if:
- You need funds for repairing your home after a natural disaster.
- You have incurred qualifying educational fees and student loans.
- You are a first-time home buyer.
- You need to pay burial or funeral costs.
- You need to pay certain medical expenses.
Pros and Cons of Using a Hardship Withdrawal
A hardship withdrawal works slightly differently from a regular withdrawal. But to determine if it’s the right option, you’ll have to consider the pros and cons.
- You’ll have easy, quick access to cash.
- You’ll be able to pay for emergency expenses that qualify, such as to pay medical debt, funeral costs, or home repairs.
- You won’t have to pay a 10% withdrawal penalty.
- You’ll still have to pay taxes on any amount you withdraw.
- You do not have to pay back the hardship withdrawal.
- It may be difficult to qualify for it.
- A hardship withdrawal can significantly impact your retirement savings.
Using a 401k Loan to Pay Off Debt
Instead of withdrawing, you can also borrow a 401k loan to pay down debts. Like any other loan, you’ll need to make regular payments until you pay off the loan.
What is a 401k Loan?
A 401k loan is a loan you can borrow from your personal 401k. Essentially, you’ll be borrowing money from yourself to pay off urgent debts to cover emergency expenses. In turn, you’ll need to pay back the money in your account.
Before using a 401k loan to pay off debts, you’ll have to meet a few IRS requirements:
- Your loan should not be over $50,000 or 50% of the account balance, whichever is lower.
- You must apply through your plan administrator.
- You must make payments at least once every quarter and pay off the loan fully within five years of taking out the loan.
It’s important to note that repayment terms will vary based on your specific plan. There may be some exceptions to the rules listed above, such as if you have borrowed money to purchase a primary residence, if you have been on a leave of absence for a year, or if you are serving in the military. Not all plans will allow you to take out a loan. For example, you can’t borrow from an IRA account.
Pros and Cons of Using a 401k Loan
401k loans offer specific advantages over withdrawals. You should also be aware of the disadvantages before you determine whether this option is right for you.
- The interest rates on 401k loans are very low, making them cheaper than most personal loans and credit cards.
- Any interest you pay will go back to your account.
- A high credit score is not a requirement for taking out a loan.
- There may be penalties and tax consequences.
- You’ll have to repay the loan quickly if you leave your job.
- It may significantly impact your retirement savings.
Using 401k to Pay Off Credit Card Debt
It may be tempting to use your 401k to get out of credit card debt if you have significant balances on your cards. While there are several ways you can go about it, every option comes with costs. Americans have most of their savings in their 401ks, and using these funds to pay off debt now while retirement is still far away can be tempting.
The average credit card interest rate is 24.72%, which is enough to make debt payments difficult for an average household without a nest egg or emergency fund. Even with such high-interest rates on credit cards, it doesn’t make sense to use your 401k to clear off your balance.
The only circumstance where you may want to think about this option is if you are over 59 ½ years old and in a very low tax bracket. Another option is to scale back or stop making contributions to your 401k until you clear your high-interest debt. Consider both of these options only if you have no other way to pay off your debt.
Benefits of Using 401k to Pay Off Credit Card Debt
The only benefit of using 401k to pay off credit card debt is that you’ll get an immediate sense of relief once your debt is cleared. There are no other benefits of going this route, and the benefits you may enjoy are only temporary if you do not address the root cause of your debt.
Drawbacks of Using 401k to Pay Off Credit Card Debt
- You’ll be in a worse position if you continue to use your credit cards after you clear the balance.
- You’ll pay a 10% penalty on your withdrawal before the age of 59 ½.
- If you’re in a high tax bracket, the amount of taxes you may pay on the withdrawal may be substantial.
- After all the taxes and penalties, the benefit you may get from saving interest charges on your credit card balance may be negated.
The Bottom Line on Using 401k to Pay Off Debts
In most cases, it’s best not to use your retirement accounts until you actually retire, especially not for paying off debts. There are several alternatives available to help you become debt-free and achieve financial freedom.
Get in touch with a professional to help explore all your options first. TurboDebt can help. Contact us for a free consultation to see what debt relief option suits you best. Our team will offer you a personalized debt relief option based on your individual needs.