Should You Be Using Your 401(k) To Pay Off Debt?

Financial challenges can hit any of us at any point in our lives. From unexpected medical bills, to a job loss, or an outstanding balance on your credit card, it’s not uncommon to rack up some debt along the way. It’s easy to feel swallowed up by unpaid debts and overwhelmed by repayment statements from lenders.

In moments of panic, you might consider dipping into your retirement savings to wipe out your outstanding balances. But before you take that drastic step, it’s essential to consider the long-term impacts. Your retirement plan is not just a piggy bank; it’s your future security.

Cashing out your 401(k) to pay off debt can severely affect your financial future. This article will explore the dangers of using your retirement funds early and all the downsides you must consider before making that move.

Understanding the Rules on 401(k) Withdrawals

Maintaining a 401(k) retirement fund is a significant achievement, but it has specific rules. These guidelines are not just arbitrary restrictions; they help ensure your financial stability in retirement. The rules for withdrawing money from your 401(k) retirement plan largely depend on your age and the type of 401(k) you have – traditional or Roth. With a traditional account, your contributions are made with pre-tax funds, whereas with a Roth account, you pay income taxes on the funds before making contributions. Early withdrawals incur taxes and fees with a traditional account, whereas a Roth account will only incur fees. We’ll get into that in the next section.

The rules of 401(k) about early withdrawal penalty fees are in place by the IRS to discourage the tapping of retirement funds too soon. They’re well aware that the power of compound interest is vital to growing your account balance, and early withdrawals can significantly dent your retirement savings.

Withdrawals Before Age 59 1/2

The rules are stringent for individuals under the age of 59 1/2. Withdrawing money before this age results in a 10% early withdrawal penalty on top of the income tax you’ll owe on the funds.

Let’s consider a hypothetical scenario. Suppose you have $50,000 in debt and decide to withdraw it from your pre-tax 401(k) to pay it off. Here’s what happens:

• You’d be hit with a 10% early withdrawal fee of $5,000. So right off the bat, you’re left with $45,000.
• But you’re not out of the woods yet. You’d still have to pay income tax on the withdrawal. The exact tax rate would depend on your tax bracket, but let’s say it’s 24%. That means you’d owe $10,800 in taxes.
• So, from your original withdrawal of $50,000, after taxes and penalties, you’re left with just $34,200. That’s quite a hefty sum to pay.

As a disclaimer, we strongly recommend talking to a financial advisor or tax professional to understand your situation before making such a decision. Additionally, your tax liability might be higher or lower depending on your total financial picture.

Typically, early withdrawals (commonly called “cashing out a 401(k)“) are seen as a last-resort option.

Withdrawals After Age 59 1/2

Once you cross the 59 1/2 age threshold, things look slightly different. The first significant difference is that you no longer have to pay the 10% early withdrawal penalty since you’re technically of retirement age.

However, you’re still liable for income tax, as you always will be for traditional 401(k) retirement withdrawals. Note that you won’t be liable for income tax if you have a Roth 401(k) that’s been in place for at least five years. In that case, the withdrawal is tax-free since your contributions were made on an after-tax basis.

But let’s assume the same scenario as we did with a traditional 401(k). You withdraw $50,000 to pay down debt, and your withdrawal amount matches the loan amount you owe.

• Since there’s no early withdrawal penalty, you won’t lose that $5,000 off the bat.
• However, income tax still applies. At a 24% tax rate, you’d owe $12,000 in taxes.
• Therefore, from your initial $50,000, you would be left with $38,000. While this is better than the previous scenario, it’s still quite a bit less than the original withdrawal.

The bottom line is that once you’re over 59 1/2, you’re in the clear regarding the early withdrawal penalty. But you still may want to consider other options to pay off debt.

What is a Hardship Withdrawal?

A hardship withdrawal is an option that allows you to withdraw money from your 401(k) before reaching 59 1/2 without incurring the 10% penalty. However, it’s important to understand that this is not necessarily the best or easiest route to debt relief.

You must prove an immediate and heavy financial need to qualify for a hardship withdrawal. The IRS has laid out specific criteria you need to meet, and it’s not a free-for-all.

Here are some situations where you might qualify for a hardship withdrawal:

• Medical expenses for you or your dependents

• A Qualified Domestic Relations Order (QDRO) mandates payments to a former spouse
• Your total or permanent disability, preventing you from earning income

Remember, your plan administrator determines whether your circumstances qualify for a hardship withdrawal. Make sure to double-check the rules of your specific retirement account via your plan’s summary document.

Other Potential Options To Pay Off Debt

If cashing out your 401(k) to pay off debt sounds too risky, it’s because it often is. Thankfully, there are other strategies you can explore for your debt payoff that won’t jeopardize your retirement savings. Let’s explore alternatives that can help, whether you’re struggling with credit card debt, student loans, etc.

401(k) Loan to Pay Off Debt

One option is to borrow from your 401(k). This should also be a last resort, but it’s typically a better option than outright withdrawal. You’re essentially borrowing from yourself, and the interest you pay goes back into your account.

However, remember that any money you borrow won’t earn compound growth while it’s out of your account, and you’ll have to engage in a payback plan. Your plan may also have restrictions about the employer match if you owe money from a loan, so speak to your plan advisor before tapping into your nest egg.

Debt Consolidation Loan

A debt consolidation loan can simplify your payments and potentially lower your interest rate. It involves taking out a new loan to pay off multiple debts, leaving you with one monthly payment. This can be a strategic option if your loans have high-interest rates and your loan payments are hard to manage.

Balance Transfer to a Low-interest Credit Card

If you have an outstanding credit card balance, this will impact your credit score. You might be able to transfer your high-interest debt to a credit card with a lower interest rate. This can save you money in the long run and make your debt more manageable.

Negotiate Interest Rates on Credit Card Debt

Speak with your lender about lowering your interest rates. Sometimes, they might be willing to negotiate if you’ve been a good customer and made payments on time. Lower interest rates make it possible to pay off your debt in a more timely manner.

Allocate Work Bonuses Toward Debt

Instead of spending work bonuses or tax refunds, use them to pay down your outstanding balances. Lump sums of money can help those in debt make significant progress.

Low-interest-rate personal loans

A personal loan can be a good option if you get a lower interest rate than what you currently pay on your debt.

Tighten Up Your Monthly Budget

Look for areas where you can cut back and use the extra money to pay down debt. Every little bit helps, so focus on budgeting to make the most of what you earn already.

Evaluate Your Financial Situation Carefully

Before making any drastic decisions, look at your overall financial situation. Consult with a financial advisor to create a plan for your unique circumstances.

Contact a Nonprofit Credit Counseling Service

Nonprofit credit counseling agencies can advise on managing your money and debt, help you devise a budget, and offer free educational materials and workshops.

Remember, when considering these options, be sure to take into account the potential impacts on your credit score, the terms of loan payments, and the rates of interest. Doing your due diligence before settling on a financial plan is essential.

In Summary

Tapping into your 401(k) to pay off debt is a decision that shouldn’t be taken lightly. If you’re under 59 1/2, the penalties and income taxes can significantly reduce your withdrawal amount. Even if you’re over 59 1/2, income tax still applies unless you have a Roth 401(k) that’s been in place for five years.

Hardship withdrawals, while an option, come with strict criteria and aren’t always the best choice for handling debt. Thankfully, several other strategies can be employed to tackle debt without compromising your retirement savings.

Whether through a 401(k) loan, debt consolidation, or simply tightening up your budget, there are ways to climb out of debt without jeopardizing your future. However, evaluating your financial situation carefully and seeking professional advice before making significant financial decisions is crucial.

With Capitalize, you have a trusted partner who can guide you through the complexities of 401(k) rollovers and manage the entire process of transferring your retirement savings.

Learn how we can help you set up your financial future today.