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.
To make an informed decision before you touch your retirement savings, you need to understand the ins and outs of your 401k plan and what it can do for you.
What Is A 401k?
Traditionally, a 401k is an employer-sponsored retirement plan made available to employees. It is a tax-advantaged plan that is geared to help you save money for retirement. A 401k is an excellent way to secure a financially secure retirement – provided you invest in it.
What Does “Tax Advantaged” Mean?
Tax-advantaged means the fund is subjected to different tax rules that generally are geared in favor of the investor. Taking advantage of these types of accounts means you can usually save and invest more money by either deferring taxes (paying them later) or being exempt from taxes (pay no tax at the end).
There are two main tax-advantaged 401k plans:
- A Roth 401k
- A Traditional 401k
How A Tax-Deferred 401k Works
A traditional 401k defers taxes until you draw money out of the account. In simple terms, your employer will take money from your paycheck and invest it in your traditional 401k before any taxes are paid to the government.
For example, if you make $5,000 a month and invest $1,000 a month in your 401k, the $1,000 will transfer from your employer to your 401k thereby lowering your paycheck to $4,000. You will then be taxed at your regular rate (income tax) on the $4,000 you receive.
The $1,000 you invest will grow over time and will not be taxed when it grows. When you decide to take money out of your 401k, after the age of 59 1/2 (more on this later) you will pay taxes on the money you take out of your account. For instance, if you are still receiving $4,000 a month and take out $1,000 from your 401k, you will pay taxes on the $5,000 in income at your regular rate.
How A Tax Exempt 401k Works
A tax-exempt 401k is referred to as a Roth 401k. While not “truly exempt” from all taxes, a Roth pays taxes upfront, but nothing on the gains or withdrawals. When you invest money in a Roth, you invest after-tax money in this account.
For instance, if you receive $5,000 a month and invest $1,000 into a Roth, your employer will pay you the $5,000 which will then be taxed at your regular rate. The money that is left after taxes is then able to be deposited into your checking account. However, rather than transferring everything to your account, $1,000 will be invested in your Roth after being taxed and the rest of the money will be deposited into your account.
After being initially invested, the tax-exempt terminology comes into play. Your money will grow over time and you will pay no taxes on it. When you take money out of your Roth 401k after the age 59 1/2, you will not pay any taxes on the additional income you draw from it – no matter how much your investment grew.
Reasons People Borrow From Their 401k
There are many reasons people dip into their retirement funds early 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 retirement savings to pay off their cards.
Using your 401k to pay off student loans
- Student loans seem to stick around forever. Most 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, people love vehicles so much they are willing to borrow from their retirement to get a reliable vehicle – or worse yet, their “dream car.”
Borrowing from your 401k to pay off your mortgage or buy a house
- The psychological benefit that comes with living without a mortgage is something that appeals to many people. Using their retirement savings 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?”
Explaining Your 401k
Before we answer the questions of whether or not you should take money out of your retirement savings to pay off debt, we need to understand how our retirement funds work, especially in regards to taxes.
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.
There are two main ways you can touch your money. You can either take cash out of your 401k, or you can take a loan out and pay yourself back.
Can I Cash Out My 401k While Still Employed?
If your 401k plan is sponsored by your current employer, you can not access this money until you leave employment or suffer a major hardship. If you have an old 401k plan from a previous employer, you can cash this out or take the cash back from it – but you may be subject to an early withdrawal penalty.
Major Hardship Withdrawal To Access 401k
There are certain situations where you can access your 401k funds while still employed. If you qualify for an IRS allowed “major hardship” you may access your money early but will still be subject to a 10% early withdrawal penalty.
According to the IRS, a major hardship withdrawal can be defined as:
- Certain medical expenses
- Costs related to buying a home
- Educational expenses
- Needing money to avoid eviction or foreclosure on a primary residence
- Primary residence necessary repairs
Generally, the IRS relies on the employer to ensure the employee takes distributions related to the hardship.
Taking Cash Out Of Your 401k
If you don’t have the extra money to pay yourself back, an option for getting extra money is to take cash out of your 401k. However, in many circumstances, you may end up paying a 10% early withdrawal tax penalty on the money you take if you are younger than 59 1/2 years old.
Tax Penalty For Taking Money Out Of Your Roth 401k Early
Since you paid initial taxes on your Roth 401k contributions, you may take your contributions back out without paying a penalty. In other words, if you invested $25,000 and your investment has grown to $50,000, you may take up to $25,000 out of your Roth without paying an early withdrawal penalty.
In contrast, if you took $30,000 out of your account, you would pay a 10% penalty on the $5,000 because that was an investment gain and more than your $25,000 contribution. However, before you run out and take your contributions out, keep reading to see the devastating impact taking your money out of your investments early can have on your retirement savings.
Tax Penalty For Taking Money Out Of Your Traditional 401k Early
If you decide to take money out of your 401k plan before you are 59 1/2 years old, you will pay a 10% early withdrawal penalty regardless of your contributions or 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.
401k Plan Early Withdrawal Penalty Exceptions
According to the IRS, several exceptions allow you to take money out of your 401k before the age of 59 1/2. The following are qualifying exemptions:
- If you die early, the government will let your beneficiaries access your retirement account without penalty
- If you have a “total and permanent” disability, as defined by the IRS, you may access your funds
- Medical Expenses
- If unreimbursed medical expenses are more than 10% of your adjusted gross income, you may access your 401k to pay for the medical bills without paying a penalty
- Military Service
- If you are reservist called to active duty, certain distributions are eligible for the exemption
**Be sure to check with a tax professional before taking money out of your 401k plan to ensure tax laws have not changed.
Should You Cash Out Your 401k To Pay Off Debt?
Before we make this decision, 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 Cash From Your 401k, Make Sure You Can Answer These Questions
The following questions need to be answered before you decide to pull from your 401k:
- How long will it take to replenish what you took out of your 401k plan, to include the 10% 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 withdrawal 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 only received $36,000. So if we want to get into semantics, you threw $4,000 out the window as well.
Are you starting to see how big of an impact taking from your retirement is?
If you are familiar with compound interest, you are familiar with the snowball effect. The more money you have in your retirement account, the faster it grows. Taking money out slows down your snowball – considerably.
Current Laws And Rules Of 401k Loans
Tax laws and IRS rules and regulations are constantly changing so always double-check the IRS website and consult with a tax professional before making any tax decisions.
How Much Can I Borrow From My 401k?
Current IRS rules allow you to borrow up to 50% of your vested account balance or $50,000, whatever amount is less. However, if your account balance is $10,000 or less, you can borrow up to the total balance or $10,000, whichever is less.
Whatever amount you borrow generally must be repaid in five years.
How Much Is A 401k Loan Interest Rate?
In 2019, the average 401k loan interest rates ranged from 6.5% to 7.5%
Borrowing From Your 401k (401k loan) To Purchase A Home
While it may be tempting to borrow from your 401k plan to purchase a home, understand that you will more than likely be paying a higher interest rate to pay back your 401k loan than you would on a traditional home loan.
Some people borrow from their 401k account for a downpayment on their primary residence. While a 401k loan is a quick way to get a down payment, keep in mind that you will now have a mortgage and 401k loan payment each month that may be difficult to sustain.
Should I Borrow From My 401k Account 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 at 16% interest. 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.
The Interest Rate On Your Debt Matters
Unfortunately, we need to remember the 10% penalty that was added on. So to pay off that $40,000 debt, we would need to take $44,444.55 out of our retirement to account for the 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 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.
High-Interest Rates And Debt
If you have a higher rate of say, 18-20%, it may make more mathematical sense to borrow against your 401k to pay off the debt. At 20%, you would have paid $23,585 in interest. With these high rates, the table begins to shift and make more mathematical sense to pay off your debts from your 401k account.
However, before you make this decision, there are a few other scenarios we need to look at that may be a better option. Also, 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 Of Borrowing From Your 401k To Pay Off Debt
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, 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 account to pay off debt, we are assuming that you will contribute back to your 401k loan aggressively. Unfortunately, there is little reward or pain associated with retirement savings. It is delayed gratification that can be easily overlooked.
If you paid your debt off with your retirement, it is easy to justify slowing down retirement 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 account is a much better option than withdrawing funds from your 401k. A 401k loan is managed through your employer and the retirement provider.
If you take a loan on your 401k, you are required to pay the loan back within a specific amount of time – 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 rate is).
In addition to the repayment rate, you do not suffer a 10% 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 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.
Use Undebt.it, A Free App To Get Out Of Debt
Undebt.it is a free app designed to get you on a plan to pay off debt based on your personality type. If you don’t know if the debt snowball or the debt avalanche is right for you, the Undebt.it app will help you make that decision. Check out Undebt.it for free here!
The Dangers Of Taking Out A Loan On Your 401k
I want to stress to you that taking out a personal loan or getting in the habit of borrowing money 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.
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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.
After the age of 59 1/2, you may take money out of your 401k without a 10% tax early withdrawal penalty.
Current IRS rules allow you to borrow up to 50% of your account balance or $50,000, whatever amount is less. However, if your account balance is $10,000 or less, you can borrow up to the total balance or $10,000, whichever is less
In 2019, the average 401k loan interest rates ranged from 6.5% to 7.5%