Paying Off Your Debt Using Your 401k

by Rick Pendykoski

Using your 401k you can wipe out your debt. And that’s not a bad thing. But it has consequences. Know what they are before you decide to take out a 401k loan.

About 40% of working Americans have an employer’s retirement plan. And 40% of those are invested in a 401k plan.

Merrill Lynch and Age Wave surveyed more than 2,700 Americans in the age group of 18 to 34 years. It reported that 25% of those with a 401k retirement plan have already pulled out money from their plan early.

Nearly a third (31%) of the respondents who made an early withdrawal against their 401ks used the money to pay credit card debt, while 16% of them put it towards their student loans.

The American debt situation is overwhelming. But the burning question is, should you use your 401k to pay your debt?

The Significance of 401ks

A 401k is a great retirement savings tool that offers tax benefits, too. The money is directly taken from your paycheck before the taxes are withdrawn, thus reducing your taxable amount, which eventually leads to you paying fewer taxes every year. The money is automatically taken from your paycheck, so you are less tempted to spend those funds. And another big benefit is that your employer can match contributions and that is practically free money you get.

Generally, 401k distributions/withdrawals are allowed when

  • You turn 59 1/2 years
  • You become disabled, can no longer work or you die
  • Your employer decides to terminate the plan with no replacement
  • You want to withdraw because of a financial hardship. However, not all employers allow withdrawing money from 401k due to financial hardship.

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Early Withdrawal Penalties

The IRS allows you to withdraw money from your 401k after you turn 59 1/2. If you take out money before that age, you are charged a 10% penalty and also need to pay the federal and state income taxes. At age 70 and above you have to compulsorily start taking out money from your 401k.

When Does Taking Money Out of a 401k to Pay Debt Make Sense?

When you have a high-interest debt, it could be beneficial to cash out a portion of your 401k to pay off the debt. However, you need to make sure that you have calculated the interest costs against the penalties you would be paying before you decide to withdraw money from your 401k.

Using a 401k Loan to Pay Off Debt

If you are not eligible for hardship distributions from a 401k and if you don’t want to pay tax penalties, you can take a loan against your 401k. These loans:

  • carry a lower interest rate than other alternative options,
  • do not impact your credit score and
  • are not taxed.

You may have to pay an origination fee, but that’s likely to be lower than the tax penalties you would be paying for early withdrawal. However, there are some restrictions to a 401k loan.

  • You can’t withdraw all you have in the retirement account. The maximum you can borrow is 50% or $50,000, whichever is less.
  • You may have to repay the 401k loans within five years. Your spouse’s consent may be taken into consideration before approving the loan.
  • You can take multiple loans, but the total amount shouldn’t exceed the limit.
  • Until you repay the loan, your employer may cease to contribute to the plan. So, when you repay, you are not actually adding to your total balance.
  • If you are no longer with your employer, the IRS may want you to repay the remaining loan amount within 60 or 90 days. If you fail to repay it in time, the amount is considered a taxable distribution. So, you may have to pay taxes as well as a 10% early withdrawal penalty.

The Takeaway

Using your 401k you can wipe out your debt. And that’s not a bad thing. But it has consequences; delayed retirement and tax penalties. And, you are putting your financial health at risk. So, evaluate your options wisely and understand the consequences of your decision before you decide.

Reviewed October 2019

About the Author

Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last 10 years has turned his focus to self-directed accounts and alternative investments. Rick regularly posts helpful tips and articles on his blog at SD Retirement as well as Business.com, SAP, MoneyForLunch, BiggerPockets, SocialMediaToday, and NuWireInvestor.

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