If you find yourself drowning in debt, using your 401k to pay off debt may seem like a viable option. In this article, we will talk about the pros and cons of using this strategy.
Reasons People Take Money Out Of Their 401k To Pay Debt
There are many reasons people dip into their retirement funds to pay off debt but there seems to be several common reasons people are willing to take this action.
Using your 401k to pay off credit card debt
- With the high interest rates associated with credit card debt, many people feel it is worth it to take money out of their retirment in order to pay off their cards.
Using your 401k to pay off student loans
- Student loans seem to stick around forever. Many people are sick and tired of paying on their student loans each month and decide to pay them off, once and for all.
Using your 401k to purchase a car
- Believe it or not, many people love vehicles so much they are willing to borrow from their retirement in order to get a reliable vehicle – or worse yet, their “dream car.”
Borrowing from your 401k to pay off your mortgage
- The psychological benefit that comes with living without a mortgage is something that appeals to many people. Using their retirement to pay off their mortgage can give people a feeling of freedom.
With all the different reasons people give as to why they borrow or take money from their 401k to pay off debt, are any of them “good ideas?”
How Your 401k Works
Before we answer the questions of whether or not you should take money out of retirement to pay off debt, we need to understand how our retirment funds work.
If you have been contributing to your 401k for an extended period of time, that lump sum may look rather tempting. If debt is destroying your relationships and finances, dipping into your retirement may look like a quick fix. Before you decide to pull money out of your 401k, you need to understand the short and long-term benefits and consequences.
Taking Money Out Of Your 401k To Pay Off Debt
First and foremost, if you decide to take money out of your 401k before you are 59 1/2 years old, you will pay a 10% early withdrawal tax penalty on the total amount withdrawn. So if you pull $40,000 out to pay a credit card bill, $4,000 of that will be going directly to Uncle Sam as a penalty. This does not take into account the additional taxes you will owe on the $40,000, because this money is added to your total taxable income for the year.
If you pull out a substantial amount, you could easily be put into a higher tax bracket. By moving up a tax bracket, your income in the higher bracket will be taxed at a higher rate than you are accustomed to, which may result in you owing money at tax season.
The Impact On Investments By Withdrawing Early
Before we talk about the investment impact, it is important to understand why our retirement accounts are so important. It is so easy to lose focus on why we are investing when retirement seems so far away. The temptation to take from our retirement to fix our current problems is a strong force. We want to stop our suffering in the here and now. I get it. Unfortunately, our future self will pay the price for fixing our current struggles with this strategy.
If you pull money out of your 401k to pay off a debt, it is important to take into account the specific impact this will have on your investments.
Before You Take From Your 401k, Make Sure You Can Answer These Questions
The following questions need to be answered before you make the decision to pull from your 401k:
- How long will it take to replenish what you took out of your 401k, to include the 10% tax penalty?
- How much money did you lose in compound interest while you were repaying your 401k?
To answer these questions, let’s look at some hypothetical examples. In sticking with our earlier $40,000 withdrawal, let’s be optimistic and assume it only takes you 5 years to replenish your fund. In that amount of time, if your $40,000 investment made the historical 8% return from the stock market, it would have grown to $58,773.12.
So in theory, to get back to where you would have been after 5 years, you would need to contribute an extra $18,773.12, or $58,773.12, in that amount of time. If you were only able to contribute the $40,000 back into your account, that $40,000 withdrawl just cost you about $19,000 over five years!
Keep in mind that by taking out the $40,000 from your account, after the penalty you realy only received $36,000. So if we want to get into semantics, you actually threw $4,000 out the window as well.
Are you starting to see how big of an impact taking from your retirment is?
If you are familiar with compound interest, you are familiar with the snowball effect. The more money you have in your retirment account, the faster it grows. Taking money out slows down your snowball – considerably.
Is It Smart To Borrow From My 401k To Pay Off Debt?
An argument for borrowing (intending to pay back) from your 401k is to eliminate a large debt with a high-interest rate. Say for instance your $40,000 debt is on a credit card with a 16% interest rate. On the outside, it may seem like a no-brainer to forfeit the 8% a year on your investment instead of paying 16% interest on that debt.
Unfortunately, we need to remember the 10% penalty that it taked on. So in order to pay off that $40,000 credit card debt, we would need to take $44,444.55 out of our retirment to account for the tax penalty.
If you take $44,444.55 – 10% Tax Penalty ($4,444.45) = $40,000.1
Had you left that money in there, in 5 years it could have grown to $65,303.63.
So, if it takes you 5 years to pay off this credit card debt, you will have paid $18,363.00 in interest to the credit card company. But you missed out on $20,859.08 in gains you could have made from your investments if you left it alone.
If you have a higher interest rate of say, 18-20%, it may make more mathematical sense to pull from your 401k for the debt. At 20%, you would have paid $23,585 in interest. With these high interest rates, the table may begin to shift and make more mathematical sense to pay for your debts from your 401k.
Before you make this decision, there are a few other scenarios we need to look at that may be a better option. In addition, I would strongly suggest that the psychological and lifestyle problems associated with paying off this debt from retirement, still outweigh any mathematical positive.
The Lifestyle Challenges
According to The Debt Payoff Playbook, retirement contributions should be paused until you tackle your debts. There are several reasons for this sequence. By forcing yourself to change your lifestyle and spending habits, you will be able to tackle your debts quickly.
This is because pain is a motivator.
When you have debt, you acutely feel the pain associated with a debt burden. This keeps you motivated to pay the debt off as fast as you can, in order to free yourself from this position. After you pay off your debt, it is less likely that you will fall back into your old spending patterns. If you do happen to fall back into debt, you will have a proven strategy to quickly change your course to get back on track.
By pulling from your 401k to pay off debt, we are assuming that you will contribute back to your 401k aggressively. Unfortunately, there is little reward or pain associated with retirement saving. It is a delayed gratification that can be easily overlooked.
If you paid your debt off with your retirement, it is easy to justify slowing down retirement in order to pay for a newer vehicle with a higher payment. It is much easier to justify lowering retirement contributions to purchase consumer goods.
The reason for this is there is much less of an emotional connection to changing retirement contributions than there is with trying to get out of debt. You will more than likely skip the new vehicle purchase while you are paying off debt because you want to stop the pain. Slowing down retirement contributions do not affect you in the here and now.
I hope you understand that the debt payoff process is as much psychological as it is mathematical. It’s about changing your lifestyle and spending habits that you have held for decades.
With a quick fix of pulling from your retirement, this huge lifestyle shift is much less likely to occur.
Is Taking A 401k Loan (Borrowing) A Good Idea?
Taking a loan out on your 401k is a much better option than withdrawing funds from your 401k. A 401k loan is managed through your employer and the retirement provider. For instance, the current rules allow you to take out a loan of up to $50,000, or half of your 401k balance, whichever is less.
If you take a loan on your 401k, you are required to pay back the loan within a specific amount of time a a predetermined interest rate, usually around 7%. By doing this, you are still in debt, but you are repaying the debt at a rate of 7% interest (or whatever your contracted interest rate is).
In addition to the repayment rate, you do not suffer a 10% tax penalty by taking a loan out on your retirement as you would pulling it directly out.
These loans are usually repaid out of your employment checks and do not allow you the choice to modify or neglect payment. By using this method, you are forcing yourself to live off less and hopefully, you will change your spending habits in the meantime. This still requires a great deal of focus from going back into credit card debt while you are repaying your 401k loan.
The Best Method To Pay Off Debt
The absolute best way to take care of that suffocating debt is to leave your retirement alone.
Do not rob your future self to pay the debts of your present self.
While you are young and healthy, you should be using this time to pay off your debts as soon as humanly possible. Pick up a side hustle, and sell everything you no longer use. Host yard sales, get on a budget and bear down to destroy this debt.
Do not pay the extra 10% tax penalty by pulling your money out early in any circumstance. There is always an alternative to taking from or borrowing from your 401k. However, you are an adult and you are going to do what you want. If you are determined to take from your retirement, at least take a loan from it instead. Force yourself to repay your future self with interest.
Other Methods To Quickly Pay Off Debt
- Take the time to contact your credit card company to negotiate a better interest rate. If the first person you talk to refuses to negotiate, ask for their supervisor and explain your situation. It never hurts to ask!
- Other credit cards may offer you a lower interest rate to transfer your balance. Be extra careful of 0% interest rate cards. They use 0% to entice you in, only to charge 20% or more after the first 0% interest year runs out. Read the fine print! Refer to The Best Way To Pay Off $10,000 In Credit Card Debt.
- If you have multiple student loans, it may make sense to consolidate them if your credit score has improved.
The Dangers Of Taking Out A Loan On Your 401k
I want to stress to you that taking a loan out or borrowing from your 401k is not a great idea. If you withdraw funds or take a loan from your 401k to pay your debts, there is no guarantee you fixed the problem that got you in debt in the first place. Remember, you are punishing your future self and your ability to retire comfortably by using it today.
Focus on getting out of debt the old fashioned way, by spending less and saving more! Build better spending habits and show your debt who’s boss!
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In most situations, if you take money out of your 401k before you are 59 1/2 years old, you will pay a 10% early withdrawal tax penalty on the amount of money you take out.
If you are not age 59 1/2, it generally is not a good idea to use your 401k to pay off debt. You will be subject to a 10% tax penalty on the funds you withdraw. In addition, you will suffer significant losses on your investments by not taking advantage of the compound interest,