Should I Use My 401(k) to Pay Off Debt?

Although 401(k) plans are financial vehicles designed to drive you to a comfortable retirement, they’re also pools of money that can help you in other ways before you retire.

Withdrawing money from your 401(k) without borrowing it usually has significant financial penalties if you’re younger than 59 ½, and isn’t a cost-efficient way to pay off debt.

Borrowing from your 401(k) plan is a better option to pay off significant debt, but it can also cost you money. Your current financial situation, retirement goals and how much debt you have all play into whether it’s a good idea to borrow from your 401(k) to pay off debt or not.

Both options depend on your financial situation, your plan’s rules, and your retirement goals.

Is Using a 401(k) to Pay Off Debt a Good Idea?

You can use money from a 401(k) plan to pay off debt, but that doesn’t mean you should. Most financial planners cringe at the notion of someone who isn’t close to retirement taking money out of their retirement plan for any reason. The financial hit that you get from penalties and taxes by simply withdrawing the money (rather than borrowing it) usually makes the debt-payment strategy not worth it.

If you withdraw the money from your 401(k) early you pay an immediate 20% withholding tax, since you didn’t pay taxes on the money before it went into the account. You also will be assessed a 10% penalty on the amount when you file your taxes.

Those penalties apply even if for most hardship withdrawals, and credit card debt doesn’t qualify as a hardship under the rules set by the Internal Revenue Service, as well as plan sponsors. You also pay the “opportunity cost” – in other words, you lose the opportunity to make money on the larger balance before the withdrawal, which accrues interest and grows.

Borrowing from your 401(k) is a better option than withdrawal to pay off debt, because there are no penalties or tax implications. The application process is usually easy, the interest is low and you’re paying it to yourself, as well as paying yourself back. You do still accrue opportunity costs, though.

Advantages

Advantages to withdrawing or borrowing from your 401(k) to pay off debt are:

• If you have high-interest debt, particularly credit cards with big balances and revolving interest, costs associated with early withdrawal, or a 401(k) loan, may be less.
• If you have upcoming debt payments and no other alternatives for paying them, borrowing from your 401(k) can reduce fees and penalties.
• If you’re about to default on a loan or go into bankruptcy, borrowing from your 401(k), or withdrawing money from it, can prevent court action, wage garnishment or asset repossession.
• If you’re about to miss credit card payments or loan payments, borrowing from your 401(k) to pay them will keep your credit score intact.
• The interest you pay on a 401(k) loan goes back into your account, unlike the interest you are paying on credit cards.

Disadvantages and Risks

The disadvantages and risks of withdrawing or borrowing from a 401(k) account, which is designed as a long-term investment are many.

• If you’re younger than 59½, withdrawing the money means significant penalties and costs.
• Any money you take out of your 401(k) will miss out on stock market gains and compound interest, reducing what your account is worth, meaning less money for you when you retire.
• Many 401(k) loans have to be repaid within five years of the borrow date. If you leave the company that sponsors your 401(k) plan before you pay off your loan, the loan balance must be paid, usually within 90 days of your departure.
• If you don’t pay a 401(k) loan back, it’s considered an early withdrawal and you must pay the interest and penalties.

What Are the Rules on 401(k) Withdrawals?

Every 401(k) plan has rules withdrawing and borrowing set by the Internal Revenue Service. The reason the IRS sets the rules is because you are not taxed on the money that goes into your 401(k) account (unless it’s a Roth 401(k)) and it’s a tax deduction.

You must begin accepting disbursements from your 401(k) at age 73 (after 2033, age 75). If you don’t, you’re assessed a penalty. You can also accept disbursements earlier, when you retire.

You can make penalty-free withdrawals from your 401(k) when you turn 59½ even if you’re not retired. If you are younger, you pay a penalty.

Each plan sponsor — your employer — also has their own rules and guidelines, and may penalize you further for early withdrawal that’s not for a qualified hardship.

Many 401(k) plans allow participants to take out loans (though they’re not required to). Vesting timelines – the amount of time you must have had the account in order to take out a loan – differ as do amounts allowed and the rules for qualification.

Your 401(k) is tied to your employment, but you don’t have to close it when you leave that employer. You can leave it alone until retirement, or you can withdraw it and roll it into another retirement plan within 60 days. If you withdraw it, but don’t roll it into another plan, it will be considered a withdrawal, and you will have to pay the penalty.

Withdrawals Before 59½

If you take money out of your 401(k) account before the age of 59½ (rather than borrow it), you pay a 10% penalty in most cases, which is assessed when you file your taxes. You also pay a 20% withholding tax immediately upon withdrawal, and may have to pay state income tax. If the withdrawal puts you into another tax bracket, you also pay higher taxes when tax time comes around.

Some employers also will not allow people who withdraw money early (except in the case of a hardship withdrawal) to continue to contribute to the 401(k) plan, or will not provide matching money.

You are also paying the “opportunity cost” of losing the interest on the money that’s no longer in your account. As interest builds on the balance of your account, the interest it accrues helps increase the balance. The younger you are when you reduce the balance, the less money there is for that exponential growth.

Rule of 55

If you leave the employer with which you have the 401(k) or are laid off any time between the year you turn 55 and when you turn 59 ½, you won’t be assessed the 10% penalty. You still have to pay income tax on the withdrawal.

Withdrawals After 59½

If you’re 59½ or older, you can withdraw money from your 401(k) without paying the 10% penalty, but you pay the 20% withholding tax immediately upon withdrawal, as well as any state taxes required. You may also have to pay higher income taxes overall if the money puts you into a higher tax bracket.

If you have a Roth 401(k), contributions are made after taxes are paid, so there’s no tax assessment upon withdrawal, as long as you’ve had the account for five years or more.

How to Borrow from Your 401(k)

You have two options for taking money out of your 401(k) before you retire. You can withdraw it or you can borrow it.

Withdrawals

Withdrawing money from your 401(k) before you are retired has serious financial repercussions in most cases. You are not borrowing the money, and you can’t put it back in. You’ll pay an immediate 20% withholding tax on what you withdraw, regardless of amount. If you’re younger than 59½, you’ll pay a 10% early withdrawal penalty when you file your taxes, in most cases.

To withdraw money, contact the plan administrator, usually someone in your employer’s human resources office. They will give you paperwork to fill out and inform you of eligibility rules and penalties. If it’s a hardship withdrawal, you’ll have to fill out a form describing the hardship. You’ll have to pay the same taxes and penalties as those who withdraw without a qualifying hardship do.

Withdrawal vs. Hardship Withdrawal

Since most hardship withdrawals carry the 10% penalty, you may wonder why anyone would bother to go the extra step to apply for a hardship withdrawal, rather than just withdrawing the money. Plan sponsors usually don’t make non-hardship withdrawals easy. This is particularly true when the employer matches your contributions, which means they’re contributing money to your retirement fund. If you withdraw the money without proving hardship, your employer may not let you continue to continue to contribute to the plan, or won’t match the contributions.

» Learn More: Should You Withdraw From Your 401(k)?

401(k) Loans

As with any other loan, you have to pay interest on a 401(k) loan. The good news is, it’s usually lower than that of other loans, and since you borrowed from yourself, the interest payments are going back into your account. The interest will help make up for some of the interest you’re losing by decreasing your account balance, but not all of it.

Your plan sponsor may have rules about how long you have to have had the account before you can borrow from it and how much, and how often, you can borrow.

The loan term is usually five years, or less if it’s a smaller loan. If it goes toward buying a primary residence, it’s 25 years. If you leave your employer before you pay the loan back, you have to pay the balance due in 90 days, or opt to take it as a withdrawal. If you do, you’ll have to pay the withholding tax assessment as well as the 10% penalty if you’re younger than 59 ½.

Does Withdrawing from Your 401(k) Hurt Your Credit?

Withdrawing money from your 401(k) has no impact on your credit. Neither an early withdrawal nor a loan affects your credit or credit score either for better or worse.  While the three credit reporting bureaus have access to just about everything in your financial world, they don’t have access to it all — and that includes your 401(k).

When Can You Withdraw from Your 401(k) Without Penalties?

You are required to immediately pay withholding taxes on any 401(k) withdrawal you take before you retire. There are exceptions, though, to paying the 10% penalty for early withdrawal. There are times when a withdrawal is necessary for legal or other reasons, and even plan sponsors who don’t offer hardship withdrawals must comply. There’s a special form, 5329, that you fill out when you file your taxes in order to waive the penalty in these circumstances:

• You are laid off or leave the employer with which you have the account any time between the year you turn 55 and when you turn 59 ½.
• You roll over your 401(k) to another retirement plan within 60 days, which is not considered a withdrawal (you also don’t pay taxes on it).
• A court order requires a 401(k) distribution as part of a divorce settlement, legally a Qualified Domestic Relations Order (QDRO).
• Your beneficiaries withdraw the money in the case of your death.
• You withdraw up to $5,000 per child for qualified birth or adoption expenses.
• A victim of domestic abuse by a spouse or domestic partner, may withdraw $10,000 or 50% of account, whichever is less.
• One distribution per calendar year for personal or family emergency expenses is allowed, up to $1,000.
• Distributions made to a terminally ill employee, on or after the date the employee has been certified by a physician as having a terminal illness.
• The employee has become disabled, with a federally qualified disability.

Hardship Withdrawal Qualifications

The IRS allows hardship withdrawals for “immediate and heavy financial need.” Plan sponsors are allowed to make their own rules, with two qualifications:

• Consumer purchases (such as a boat or television) are not considered an immediate and heavy financial need.
• A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee.

The withdrawal can’t be greater than the amount of the “immediate and heavy financial need,” including what’s necessary to pay any taxes resulting from the distribution.

Hardship withdrawals come with the same 10% penalty and tax assessments a non-hardship withdrawal does, unless they come under the exceptions listed above.

The IRS has a “safe harbor” provision that allows employers who offer a hardship withdrawal to define certain situations as qualifying without a lot of extra red tape. These include:

• Certain medical costs
• Payments for avoiding eviction from or foreclosure on a principal residence
• Expenses to pay for a major repair of a principal residence
• Expenses and losses from a natural disaster (hurricane, tornado, fire or flood) provided the principal residence fall within a federally declared disaster zone
• Down payments and costs to buy a principal residence
• Tuition and other related educational expenses
• Burial or funeral expenses.

Alternative Ways to Pay Off Debt

If withdrawing or borrowing from your 401(k) to pay off credit card debt, or other debt, isn’t something you want to do, or are able to, you still have options.

Debt Management Plan

A debt management plan will reduce your monthly payments and pay off your credit card debt in 3-5 years. You make one monthly payment to a nonprofit credit counseling agency, like InCharge Debt Solutions, and the agency’s counselor works with your creditors to lower interest rates and waive fees. It’s not a loan, and you end up paying the full amount you owe, but it’s a good way to lower your monthly payments and get those credit card balances down to zero.

Debt Consolidation

If your credit score is good, you may qualify for a debt consolidation loan that has lower interest than your credit cards, as well as an end date, which means you’ll pay less monthly and less in the long run. Making payments on a debt consolidation loan, as long as they’re on time and you don’t run your credit cards back up, will improve your credit score. That means that future credit will be at a lower interest rate and on better terms.

Talk to a Credit Counselor

One alternative to borrowing or withdrawing  from your 401(k) is to have a professional financial expert help you navigate your options first. A credit counselor at a nonprofit agency will review your budget with you and suggest resources or other debt relief options that will work with your budget and preserve your retirement savings.

Representatives for InCharge Debt Solutions provide free nonprofit credit counseling through an online chat or on the phone. They’ll help you navigate through various choices and help you understand the pros and cons of each one.