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Should you use your 401(k) to pay off debt?

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

Updated

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 or fees 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 process 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. Early withdrawals and 401(k) loans are limited to $100,000.
  • 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 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’ll have two to three months to repay the entirety of your loan before you default.

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 limited to a five-year term, 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?

Both an early withdrawal and a 401(k) loan let you access up to $100,000 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. Choose to get a lump sum in 2020, or spread evenly over the next three years. Also, 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 but loan payments are suspended for a year, extending the standard five-year 401(k) loan term to six 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 leave your employer, you have until mid-October of the following year to repay 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 taxes on the distribution but can claim a refund if you pay back what you withdraw within three years.

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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