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Should You Use a 401(k) to Pay Off Debt?

Posted on March 28th, 2022
Retirement Annuity is Better Than a 401

As we all know, 401(k) plans are a great way to save for retirement. However, if you have a lot of debt, cashing out your 401(k) is an option; but is it a good option? In this article, we will discuss all the pros and cons of using your 401(k) savings to pay off debt. We will also explore some alternative methods for paying off debt so that you don’t have to rebuild your retirement fund from scratch.

What Is a 401(k)?

A 401(k) plan is a retirement savings plan. The money you contribute to your 401(k) plan is not taxed until you withdraw it; in other words, your savings will be tax-deferred as they grow.

There are two types of 401(k) plans: Traditional and Roth. With a traditional 401(k), you will not pay taxes on the money that you contribute until you withdraw it. On the other hand, with a Roth 401(k), you pay taxes on the money you contribute, but you don’t have to pay taxes when you withdraw it in bulk. Another difference between a traditional and Roth 401(k) is that the former lets you take a loan from your account. With a Roth 401(k), you cannot touch the savings until you’re retired.

How Does a 401(k) Plan Work?

When you contribute to a regular 401(k) plan, you are making pre-tax contributions from your paycheck. That means your money won’t be taxed until you withdraw it, and if you take out a loan against yourself and pay it back in time, that won’t be taxed either. Upon retiring, you will be required to pay taxes on the money you have withdrawn from your account. We’ll discuss all your options for pre-retirement 401(k) funding below, but we’ll go over the 401(k) basics first.

The amount of taxes you pay will depend on your tax bracket at the time of withdrawal. This is important to note as it means that you could end up paying more in taxes on the money you withdraw from your 401(k) at retirement than you would have if you had just taken the money out of your paycheck and paid taxes on it upfront. You should also ensure that you do not withdraw more money than you anticipate needing after retiring.

Finally, once you begin “vesting” your 401(k) money, you might be barred from withdrawing for a while. If you’re looking into 401(k) loans, your first stop would be to make sure this is not the current state of your affairs.

Getting a 401(k) Plan

Some employers offer 401(k) plans to their employees to attract and retain talent, but not all of them. If your employer does not provide a 401(k), you can still open an account at several different investment firms with the same purpose. Once you do that, you can start contributing to your retirement savings.

When Can You Start Using Your 401(k)?

You can start using your 401(K) as soon as you have vested in the account. The vesting schedule varies from plan to plan, but it is typically between one and five years. To determine how long you need to be employed before becoming vested, you can check your employee handbook or contact your employer. If you don’t yet have access to your 401(k) funds, you can look at alternatives, such as taking out a personal loan or using a credit card.

What Is a 401(k) Loan?

A 401(k) loan gets taken out against your 401(k) savings. Taking out a 401(k) loan is practically borrowing from yourself. This means that the interest you pay on a loan goes back into your account. However, just like with any other loan, you’re taking a risk: If you can’t pay it back, you might be left without retirement savings.

This loan’s name comes from the section of the tax code that governs it. Under section 401(k) of the tax code, you are allowed to borrow up to $50,000 or 50% of your vested account balance (whichever is less) from your 401(k).

Another important thing about 401(k) loans is that they are not tax-deductible, meaning that you will have to pay taxes on the money you borrow. The money you decide to withdraw can be used for any purpose, but it will be treated as a withdrawal and taxed accordingly if you don’t repay it within five years.

Costs Associated with 401(k) Loans and Withdrawals

We mentioned some costs associated with taking out a loan or making a withdrawal from your 401(k) account. These include taxes and penalties.

If you take out a loan from your 401(k), you will have to pay interest on the loan. The interest rate is usually lower than the rate you would pay on a personal loan, but it is still worth considering. Additionally, if you withdraw from your 401(k), you will have to pay taxes and penalties on the amount.

The tax rate will depend on your income level and the type of withdrawal you made. For example, if you take out a hardship withdrawal, you may have to pay an additional penalty if the amount exceeds $10,000, and you won’t be able to pay it back, only contribute to your 401(k) later. Also, if you are under the age of 59 ½, you will likely have to pay a 10% penalty on the amount you withdrew.

Using 401(k) to Pay Off Debt

Now, here’s the part we have all been waiting for: We’ve discussed what 401(k) is and how it works, so let’s now see if it’s a good idea to cash it out 401(k) to pay off debt. There are two ways of using 401(k) to pay off debt: Taking out a loan or making a withdrawal.

401(k) Loans

As mentioned before, this option lets you borrow from yourself, and the interest you pay on the loan goes back into your own account. This can be a good option if you need a large sum of money and don’t want to pay taxes or penalties on the withdrawal. However, there are some drawbacks to this option.

For one, if you leave your job for any reason (including being fired), you will likely have to repay the loan in full within 60 days, or it will be considered a withdrawal, and you will be subject to taxes and penalties. Second, if you can’t repay the loan within your repayment period for any reason, it will be treated as a withdrawal, and you will owe taxes and penalties on the amount you borrowed.

401(k) Withdrawals

The second method is to withdraw from your 401(k) account. This is less desirable than taking out a loan because you will have to pay taxes and penalties on the amount you withdraw.

However, if you are in a situation where you can’t take out a loan or don’t want to repay it, this may be your only option. You will have to pay taxes on the amount you withdrew in the same year you made the withdrawal.

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

Here are some of the key benefits of using 401(k) to pay off debt:

Repayment Flexibility

One of the most significant benefits of using your 401(k) savings to pay off debt is repayment flexibility. You can choose how to repay it: You can either make monthly payments or repay the entire amount at once. Additionally, if you take out a loan from your 401(k), you have up to five years to repay it.

Lower Interest Rates

Another benefit of using your 401(k) to pay off debt is the lower interest rate than you would get on a personal loan. Additionally, if you make a withdrawal from your 401(k), you will only have to pay taxes on the amount you withdraw, which may be lower than the interest rate on your debt.

Tax Benefits

Another advantage of using 401(k) to pay off debt is tax benefits. You can reduce the amount of taxable income you have and save money on taxes. For example, if you have a 401(k) loan, you can deduct the interest you pay on the loan from your taxes. Additionally, if you make a withdrawal from your 401(k), you may be able to avoid paying taxes on the withdrawal if you repay the withdrawal in time.

Convenience and Speed

Using your 401(k) to pay off debt is a fast and convenient way to get the money you need. This is because you can usually get the money within a few days of applying for the loan or withdrawal. There are no lengthy applications or approval processes.

Why Is It a Bad Idea To Use 401(k) To Pay Off Debt?

While there are considerable benefits to using 401(k) to pay off debt, there are also some downsides to keep in mind:

Balloon Payment Risk

One of the significant downsides of using your retirement savings to pay off debt is that you may not have enough money in your account to cover it. You could end up taking out a loan or making a withdrawal from your 401(k) and be unable to repay it, and ending up with a balloon payment that puts you in a worse position than your original debt.

Losing Your Job

Another thing you should consider before using your 401(k) savings to pay off debt is the possibility of losing your job. If you take out this loan and lose your job, your repayment window shortens. Before the 2017 Tax Cuts and Jobs Act passed, that window was a strict 60 days, but now it can be extended. Still, if you can’t repay the loan within that time, it will be considered a withdrawal, and you will have to pay taxes on the amount you withdrew.

No Financial Cushion

The most apparent downside of using your 401(k) to pay off debt is that you may lose your financial cushion. Your 401(k) account balance fluctuates with the stock market, since you’re investing your money to grow over time. If there are significant stock market downturns, your 401(k) investments will likely follow suit. This could leave you without the money you need to cover unexpected expenses or emergencies. Therefore, it’s essential to consider whether you can afford to lose your 401(k) account balance before using it to pay off debt.

Slow Repayment

Another downside of using 401(k) to pay off debt is that it’s unlikely you will be able to repay the loan quickly. The average 401(k) loan term is five years, and if you can’t repay the loan within this time, you may have to face a penalty for defaulting on the loan. This can be a costly mistake that can set you back financially, which is why it’s important to only take out a 401(k) loan if you are certain you can repay it within the given frame, and preferably sooner.

Alternatives to Using 401(K) Money To Pay Off Debt

Now that you know the possible pros and cons of using your 401(k) to pay off debt, let’s also look at some of the alternatives.

Personal Loan

A personal loan can be a decent alternative to using 401(k) money before retirement. Personal loans have higher interest than 401(k) loans, but lower than credit cards. You will also have a set repayment schedule, which can help you get out of debt faster. 

You can get these loans from a few different places: eBanks, credit unions, or online lending services are all at your disposal. If you go for the first option, you will need to provide your credit score and income information. If you go for the second, you don’t have to provide your credit score, but you may be required to provide other personal information, such as your address and Social Security number. Finally, online lending services usually have the fewest prerequisites, but are ripe grounds for predatory loans, so you have to be extra careful when choosing between them.

Credit Card

If you have a high limit on your credit card, you can use it to pay off your debt. This will allow you to avoid the fees and penalties associated with 401(k) loans.

However, using a credit card to pay off debt can be risky.

For one, credit cards generally have the highest interest rates of all the borrowing varieties. Not only that, but if you’re unable to make payments on time, you will end up being charged late fees. This can add up quickly and leave you with even more debt than you started with. On the plus side, if you get a card with a promotional 0% APR period, you might be able to pay off your debts on the cheap.

Debt Consolidation Loan

If you have several different debts, you may want to consider a debt consolidation loan. This is a loan specifically aimed at paying off multiple debts simultaneously. Namely, the interest rate on a debt consolidation loan is typically lower than the interest rates on your credit cards and some personal loans. 

This can save you money and help you get out of debt faster, but it is vital to ensure you can afford the monthly payments. Also, debt consolidation tends to reflect badly on your credit score, so that’s another thing to keep in mind.

Home Equity Line of Credit

If you own a home and need quick cash to pay off a debt, you may be able to get a home equity line of credit (HELOC). As the name suggests, this loan is secured by your home equity. HELOCs typically have lower interest rates than unsecured loans (e.g., personal loans). However, if you default on the loan, your home could be foreclosed. In other words, this should be your last resort for paying off debt.

Payday Loans

Similar to HELOCs, payday loans aren’t the ideal way of getting out of debt. These are short-term loans that are typically due on your next payday. The interest rate on payday loans is high, and if you can’t repay the loan when it’s due, you may be charged additional fees. This can quickly turn a small loan into a large debt, which is why they’re typically only meant for smaller short-term expenses, such as car repairs or modest medical bills.

How Does Cashing Out Your 401(k) Work?

When you cash out your 401(k), not borrow it, you will have to pay taxes on the money that you withdraw, as well as a 10% penalty if you are under the age of 59 ½. The reason for the tax and penalty is that when you take the money out of your 401(k), you are not just taking out the contributions that you have made, but also the earnings on those contributions. This is different from taking a loan from your 401(k) because, with a loan, you are only borrowing the contributions, not the earnings.

When considering cashing out your 401(k), keep in mind that you are losing the opportunity to continue receiving tax-deferred earnings on the money you withdraw. Most importantly, if you cash out your 401(k), you will not have any money saved for retirement.

Minimizing the Risks To Your Retirement Fund

There are also other ways to minimize the risks to your retirement fund. For example, if you are in debt and can’t afford the monthly payments, you may want to consider a debt management plan. This is a plan where you make one monthly payment to a credit counseling agency, which then uses the money to pay off your debts. This can help you get out of debt faster and avoid late fees and interest charges.

Additionally, if you are in danger of defaulting on your student loans specifically, you may want to consider student loan consolidation. That way, you’ll combine all your student loans into one loan with a lower interest rate. This can help you save money over the life of your loan and make the monthly payments more affordable. If you can, continue making contributions to your retirement fund; however, even if you can’t afford to do that, just leaving it alone for the duration of repaying your current loans is better than cashing it out. You’ll thank yourself when you reach retirement.

Aside from these possibilities, there are a few others to think about, as well. You could take a cash advance from your credit card, borrow money from family or friends, or even sell some of your possessions. However, each of these options come with their own set of risks and should be considered carefully before moving forward. Nonetheless, they’re usually a better option than risking the savings you’ll need once you’re no longer able to work.

Bottom Line

In conclusion, there are a few things to think about before borrowing from your 401(k) or cashing it out to pay off debt. While it may be tempting to do either of those, you need to consider the taxes and penalties you will incur, as well as the loss of financial security for your future.

If you are having trouble making ends meet, it may be worth considering alternatives to minimize the risks to your retirement fund. However, if you can realistically borrow the money, pay it back in a reasonable amount of time, and aren’t too close to retiring, getting money out of your 401(k) account might be viable.

Either way, it is crucial to stay informed and base your decision both on your current situation and the long-term financial goals you are trying to reach. So, what do you think? Is cashing out your 401(k) to pay off debt a good idea or a bad idea? Let us know in the comments below.

Aleksandra Arsic

Aleksandra Arsic

Aleksandra is a creative spirit, passionate about everything related to finance. She discovered her true calling during her studies. Struggling to balance her student loan debt, the cost of daily life, with her wants and needs, she looked for ways how to manage her finances in the most efficient way. Now, she wants to help people achieve the same, and enjoy financial security while making well-informed financial decisions. Since Fortunly is a platform focused on finances, it seemed like the perfect place for her to spread the knowledge and experience she gained over the years.

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