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Is taking money out of 401k to pay debt a good idea?

Weigh the potential tax penalties vs. interest savings before you decide.

If you have a nest egg saved up in your 401(k), it might be tempting to use it to pay off your debt. But with early withdrawal penalties, taxes and interest if you take out a 401(k) loan, it could end up costing you more in the long run.

Pros and cons of using your 401k to pay off debt

Pros

  • Quick access to cash. Funds from a 401(k) disbursement or loan are typically available within one to two weeks.
  • Simple application process. Instead of completing a convoluted application with a third-party lender, accessing funds from your 401(k) only requires a meeting with your company’s HR department.
  • No credit check. It’s easier to qualify for a 401(k) loan than a traditional loan because 401(k) loans don’t require a credit check.

Cons

  • Withdrawal limit. 401(k) loans are limited to $50,000.
  • Lost returns. Even if you replace what you withdraw, it won’t be possible to catch up on account losses from compounded interest.
  • Early withdrawal penalty. Opting for a 401(k) withdrawal? Unless it qualifies as a hardship withdrawal, you’ll likely be slammed with a 10% penalty. This penalty also applies to any funds you’ve failed to pay on a 401(k) loan after your repayment term.
  • Loan repayment risks. If you lose your job after taking out a 401(k) loan, you may have to pay it all back in as little as two to three months before you default.

The costs of using your 401(k) to pay off debt

If you withdraw money from your 401(k) before reaching age 59.5, you’ll trigger a 10% early withdrawal penalty. So if you withdraw $50,000 from your 401(k), your first hit is a $5,000 early withdrawal penalty.

Regardless of age, you’d owe income tax on 401(k) withdrawals. So if you’re in the 22% tax bracket, that’s an $11,000 tax.

When you do the math, your 401(k) withdrawal will cost you $16,000 next time you file your tax return. Plus, the IRS generally requires an automatic 20% withholding from early withdrawals. That means you may only get $40,000. When considering all this new debt in the form of taxation, you’re only left with $24,000 to pay your old debt.

However, you may be better off borrowing from your 401(k) if your plan allows it.

What is a 401(k) loan?

401(k) loans don’t trigger early withdrawal penalties or taxes. Of course, you’d pay interest on a 401(k) loan. But 401(k) loan interest rates are generally lower than the tax and penalty rates you’d pay on early withdrawals.

401(k) loan interest rates are typically a percent or two above the prime rate. The prime rate is currently about 3.25%, which is lower than the penalty alone.

Plus, you’d be paying yourself back. The loan payments and interest go back into your account. You generally have up to five years to pay back a 401(k) loan. The IRS states these loans must be repaid in “substantially equal payments that include principal and interest and that are paid at least quarterly.”

But a 401(k) loan can backfire if you change or leave jobs before you pay it back. When this happens, you must pay back the loan within a grace period that can be as short as a few months. If you don’t pay it back, you’d owe income tax on the remaining balance plus a 10% early withdrawal penalty if you’re younger than 59.5.

COVID-19 Changes to 401(k) loans

You may have heard that the CARES Act triggered by the COVID-19 pandemic increased the amount you could borrow from a 401(k) and how long you had to pay it back. But those provisions expired at the end of 2020. The 401(k) loan limit was raised to $100,000. But that expired at the end of 2020. It’s now $50,000 as it was before.

Should I pay off my credit card debt with a 401(k) loan?

Considering the high interest rates on most credit cards, a 401(k) loan can be pretty attractive to help you pay off that debt. It also doesn’t require a credit check, which can make it easier to qualify for than a debt consolidation loan or balance transfer credit card.

But you still run the risk of penalties, taxes and running up big balances again unless you change your spending habits.

Should I pay off my student loans with a 401(k) loan?

Because of the penalties for withdrawing money from your 401(k) early, you might not want to. And since 401(k) loans are usually limited to six-year repayment terms, it might be difficult to pay off a high student loan balance in that short amount of time.

Student loans also come with more flexible repayment options and lower interest rates than other types of debt, so it might not help you save much.

A better option might be to stop making 401(k) contributions and apply the money toward your student loans. The downside is you’ll miss out on compounding interest and any contributions by your employer. You’ll also reduce the money that is supposed to go toward your retirement.

What’s the difference between a 401(k) loan and an early withdrawal?

Early withdrawals and 401(k) loans give you to access money from your retirement funds, but there are a few key differences to be mindful of.

  • If you opt for an early withdrawal, you don’t have to repay what you withdraw — but you pay taxes on it. If you pay the distribution back within three years, you can claim a refund on the taxes you paid.
  • If you take out a loan, you’re expected to pay back what you withdraw within five years. What you withdraw is tax free, but anything you still owe at the end of your loan term is taxed as a withdrawal and subject to the standard 10% early withdrawal penalty if you’re under the age of 59.5.

If you leave your employer, you typically have a few months to pay the entirety of your 401(k) loan.

Which one should I choose?

The best way to access your 401(k) funds depends on where you see yourself in the coming years — specifically in terms of employment.

Choose a 401(k) loan if you plan to stick with your current employer for at least the next five years. Whatever amount you withdraw is tax-free and you’ll have six years to repay the loan.

Choose an early withdrawal if you don’t plan to stay at your current job. You’ll have to pay income taxes on the distribution.

Alternatives to using your 401(k)

There are better alternatives to paying off debt than withdrawing funds from your 401(k) or taking out a 401(k) loan. Here are several to consider:

  • Balance transfer credit card. Transferring your credit card balances to one with a 0% intro period can help you save on interest while getting out of debt faster.
  • Personal loan. If you have good credit, you might qualify for a personal loan with a competitive interest rate. Many can be paid back over a longer period of time — some up to seven years.
  • Take out a loan against your life insurance. If your life insurance policy lets you build up a cash surrender value, you could be eligible for a loan. They usually come with a lower interest rate and may be a good option if the cash value is significant.
  • Tighten your belt. This is the most obvious option, but also the most painful. If you’re really serious about paying down your debt, reducing your standard of living can equal a big payoff in the end.
  • Debt relief programs. Under these programs, you may pay less than the balance you owe, which will offset some of the taxes and fees you have with early 401(k) withdrawals.

Should I use my IRA instead?

You can use your traditional IRA to pay down debt, but as with a 401(k), any withdrawals before the age of 59 and a half are subject to taxes and a 10% penalty. However, there are exceptions, like disability, qualified education expenses and death.
If you have a Roth IRA, you can withdraw funds tax free if you’ve had the money in the account for at least five years. But you’re limited to what you’ve contributed. And if you’re under the age of 59 and a half, any part of the withdrawal that comes from investment earnings is subject to taxes and to the 10% penalty.

Bottom line

Paying off debt with your 401(k) might sound like a good idea in theory, but the early withdrawal penalties or fees and interest that come with a 401(k) loan might make you want to think twice. Instead, read up on other debt consolidation options to help you decide which is best for you.

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