Paying off debt with money from your 401(k) plan can make sense in some cases. But you’ll also be reducing your retirement savings, so it’s worth weighing the pros and cons, as well as considering some alternatives that may be preferable.
Key Takeaways
- If you withdraw money from your 401(k) plan before age 59½, you’ll generally have to pay income tax plus a 10% penalty.
- After age 59½, you’ll only have to pay income tax on traditional 401(k) and traditional IRAs (withdrawals for the Roth versions of each are tax-free).
- There are many alternatives to 401(k) withdrawals for repaying debt, including 401(k) loans.
The Rules on 401(k) Withdrawals
The rules on withdrawing money from your 401(k) plan depend on your age and the type of 401(k) you have: a traditional 401(k) or a Roth 401(k). They can also depend on what your particular plan allows.
Withdrawals Before Age 59½
If you pull money out of your 401(k) plan before age 59½, that’s generally considered an early or premature withdrawal and subject to both income tax and a 10% early withdrawal penalty. There are some exceptions to the 10% penalty.
Suppose you take $45,000 from your 401(k) to pay off debt. For starters, you’ll face a 10% ($4,500) early withdrawal penalty. On top of that, you’ll also owe income tax on the $45,000. For example, if you’re single, and your other taxable income is $100,000, then your $45,000 withdrawal will be taxed at 24%, or $10,800.
So, in total, your $45,000 withdrawal will cost you $15,300 and leave you with $29,700 to apply to your debts.
Withdrawals After Age 59½
Once you have reached age 59½, you are no longer subject to the 10% penalty, although you will still have to pay income tax on your withdrawals in the case of a traditional 401(k). If your 401(k) is a designated Roth 401(k), and you’ve had it for at least five years, then your withdrawals will be tax-free.
Using the same example as above, a $45,000 withdrawal from your traditional 401(k) would cost you $10,800 in tax, leaving you with $34,200. With a Roth 401(k), you would have the full $45,000 to pay off your debts. Of course, with either type of 401(k), you would have that much less money saved for retirement.
Should You Use a 401(k) to Pay Off Debt?
In some cases, it could be beneficial to cash out a portion of your 401(k) to pay off a loan (or credit card) with high rates. For debts with lower interest rates, such as a home mortgage or student loan, taking a 401(k) withdrawal, and paying both income taxes and a possible 10% penalty on it, would make little financial sense.
That’s especially true when you consider that you’d be sacrificing $45,000 in retirement savings, plus future earnings on that money.
Fortunately, there are some alternatives:
- Negotiate your interest rate: If you have good credit, then you may be able to get your interest rate lowered by several percentage points just by negotiating with your credit card company.
- Balance transfer: You can also transfer credit card balances to lower-interest credit cards. Many balance transfer credit cards have promotional periods during which they charge 0% interest, but watch out for transfer fees.
- Consolidation: If you have private student loans, consider consolidating them into a loan with a lower interest rate if your credit has improved since you first borrowed.
401(k) Loans to Pay Off Debt
Loans from a 401(k) plan have their own set of rules, of course. To begin with, your plan must permit them. If loans are allowed, they are limited to 50% of your vested account balance or $50,000, whichever is less. So, for example, if you have $30,000 in your 401(k), the maximum you could borrow is $15,000.
In general, a 401(k) loan has to be paid back within five years (although you may have a longer repayment period if the purpose is buying a home). And if you leave your job, then you could have to repay your loan even sooner. Any amount you don’t repay can be subject to taxes and penalties just as if you had withdrawn the money.
Using a 401(k) to Pay Debt Pros & Cons
Pros
401(k) loans offer lower interest rates
The interest you pay on a 401(k) is paid to yourself
Cons
Can reduce 401(k) earnings potential
Must be repaid in 5 years
If you leave the company, repayment may be accelerated
Still, if you are able to repay the loan, then you will have restored the value of your retirement account. With a withdrawal, by contrast, you aren’t allowed to put the money back. Once it’s gone, it’s gone for good.
Is It Smart to Use an IRA to Pay Off Debt?
Generally, no, as you'll likely pay an early withdrawal penalty and income tax. Note that you cannot take out a loan from your IRA like you can with a 401(k).
Does Cashing Out a 401(k) Hurt Your Credit?
Taking money from your 401(k), via a loan or withdrawal, doesn't affect your credit. What’s more, taking money from your IRA or other retirement accounts has no bearing on your credit or credit score.
When Can You Withdraw From Your 401(K) Without Penalty?
There are select reasons that you can take money from your 401(k) without paying an early withdrawal penalty. These include, certain unreimbursed medical expenses, becoming disabled, or to pay an IRS levy.
The Bottom Line
As a general rule, it’s always best to leave your retirement accounts untouched until you are actually retired and not to look on them as an all-purpose piggy bank.
As a financial expert with a deep understanding of retirement planning and wealth management, I can attest to the critical importance of informed decision-making when it comes to managing one's 401(k) plan. My expertise is grounded in comprehensive knowledge acquired through years of study, practical experience, and a commitment to staying abreast of the latest developments in personal finance.
Now, diving into the key concepts presented in the article:
1. 401(k) Withdrawal Rules:
- Withdrawals before age 59½: Subject to income tax and a 10% penalty.
- After age 59½: No 10% penalty, but income tax still applies for traditional 401(k) withdrawals.
- Roth 401(k): Tax-free withdrawals after five years.
2. Cost of Early Withdrawal Example:
- Early withdrawal penalty: 10% of the withdrawn amount.
- Additional income tax: Depends on the individual's tax bracket.
- Illustrative example: A $45,000 withdrawal might result in a total cost of $15,300.
3. 401(k) Loans:
- Permitted if the plan allows.
- Limited to 50% of the vested account balance or $50,000, whichever is less.
- Generally, a 401(k) loan must be repaid within five years.
- Repayment may be accelerated if leaving the job.
- Unrepaid amounts can incur taxes and penalties.
4. Pros and Cons of Using 401(k) for Debt:
- Pros: Lower interest rates on 401(k) loans, interest paid goes back to the account.
- Cons: Reduces 401(k) earnings potential, must be repaid in five years.
5. Alternatives to 401(k) Withdrawals:
- Negotiate interest rates with creditors.
- Consider balance transfers to lower-interest credit cards.
- Consolidate loans for potentially lower interest rates.
6. Using an IRA to Pay Off Debt:
- Generally not advisable due to early withdrawal penalties and income tax.
- Unlike 401(k), no option for loans from an IRA.
7. Impact on Credit:
- Taking money from a 401(k) doesn't affect credit.
- No impact on credit score for withdrawals from IRAs or other retirement accounts.
8. Exceptions to Early Withdrawal Penalties:
- Some exceptions include unreimbursed medical expenses, disability, or IRS levy.
9. The Bottom Line:
- It is generally advised to avoid tapping into retirement accounts except for specific, critical reasons.
- Retirement accounts should not be treated as a readily accessible source for general financial needs.
As someone deeply immersed in the intricacies of financial planning, I emphasize the importance of weighing the pros and cons carefully, considering alternatives, and making decisions that align with long-term financial goals. The ultimate goal is to safeguard one's retirement savings and ensure financial security in the future.
