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

Learn which rare situations merit tapping your retirement funds

Reviewed by David Kindness

Paying off debt with money from your 401(k) plan can make sense in some cases. But you’ll also be reducing your retirement savings, so it’s worth weighing the pros and cons, as well as considering some alternatives that may be preferable.

Key Takeaways

• If you withdraw money from your 401(k) plan before age 59½, you’ll generally have to pay income tax plus a 10% penalty, though there are a few exceptions.
• After age 59½, you’ll only have to pay income tax on traditional 401(k)s and traditional IRAs. Withdrawals for the Roth versions of each are tax-free.
• There are many alternatives to 401(k) withdrawals for repaying debt, including 401(k) loans.

The Rules of 401(k) Withdrawals

The rules of 401(k) withdrawals depend on your age and the type of 401(k) you have: a traditional 401(k) or a Roth 401(k).

Withdrawals Before Age 59½

If you pull money out of your 401(k) plan before age 59½, that’s generally considered an early or premature withdrawal. This means in addition to paying income tax on the withdrawal (unless it’s a Roth account that you’ve had for more than five years), you’ll need to pay a 10% penalty. However, there are some exceptions to this early withdrawal penalty.

Suppose you take $50,000 from your traditional 401(k) to pay off debt. For starters, you’ll face a 10% ($5,000) early withdrawal penalty. On top of that, you’ll also owe income tax on the $50,000. For example, if your effective tax rate is 17%, then your $50,000 withdrawal will be taxed at 17%, or $8,500.

So in total, your $50,000 withdrawal will cost you $13,500 and leave you with $36,500 to apply to your debts.

Withdrawals After Age 59½

Once you have reached age 59½, your withdrawals are no longer subject to the 10% penalty, although you will still have to pay income tax on your withdrawals in the case of a traditional 401(k). If your 401(k) is a designated Roth 401(k), and you’ve had it for at least five years, then your withdrawals will be tax-free.

Using the same example as above, a $50,000 withdrawal from your traditional 401(k) with no penalty would cost you $8,500 in tax, leaving you with $41,500.

With a Roth 401(k), you would have the full $50,000 to pay off your debts.

Of course, with either type of 401(k), you would have that much less money saved for retirement.

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

In some cases, it might be beneficial to cash out a portion of your 401(k) to pay off a loan or credit card with high rates. For debts with lower interest rates, such as a home mortgage or student loan, taking a 401(k) withdrawal, and paying both income taxes and a possible 10% penalty on it, would make little financial sense.

That’s especially true when you consider that you’d be sacrificing $50,000 in retirement savings, plus future earnings on that money.

Fortunately, there are some alternatives:

• Negotiate your interest rate: If you have good credit, then you may be able to get your interest rate lowered by several percentage points just by negotiating with your credit card company.
• Balance transfer: You can also transfer credit card balances to lower-interest credit cards. Many balance transfer credit cards have promotional periods during which they charge 0% interest, but watch out for transfer fees.
• Consolidation: If you have private student loans, consider consolidating them into a loan with a lower interest rate if your credit has improved since you first borrowed.

Warning

A 401(k) loan typically needs to be repaid within five years.

401(k) Loans to Pay Off Debt

Loans from a 401(k) plan have their own set of rules. To begin with, your plan must permit them. If loans are allowed, they are limited to “(1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less,” according to the Internal Revenue Service (IRS). So, for example, if you have $30,000 in your 401(k), the maximum you could borrow is $15,000.

In general, a 401(k) loan has to be paid back within five years, although you may have a longer repayment period if the purpose is buying a home. And if you leave your job for any reason, then you’ll need to repay your loan even sooner — you’ll have until the following Tax Day, either in mid-April or, if you file for an extension, until mid-October.

Pros

• 401(k) loans offer lower interest rates

• The interest you pay on a 401(k) loan is paid to yourself

Cons

• Can reduce 401(k) earnings potential

• Typically must be repaid in five years

• If you leave the company, repayment is accelerated

Still, if you are able to repay the loan, then you will have restored the value of your retirement account. With a withdrawal, by contrast, you aren’t allowed to put the money back. Once it’s gone, it’s gone for good.

Is It Smart to Use an IRA to Pay Off Debt?

Generally, it isn’t a good idea to use an individual retirement account (IRA) to pay down debt, as you’ll likely pay an early withdrawal penalty and income tax. Note that you cannot take out a loan from your IRA like you can with a 401(k).

Does Cashing Out a 401(k) Hurt Your Credit?

Taking money from your 401(k) via a loan or a withdrawal doesn’t affect your credit. Taking money from your IRA or other retirement accounts has no bearing on your credit or credit score, either.

When Can You Withdraw From Your 401(K) Without Penalty?

There are a few exceptions to the early withdrawal penalty rule for 401(k)s. These include paying for certain unreimbursed medical expenses, becoming disabled, and facing an IRS levy.

The Bottom Line

As a general rule, it’s best to leave your retirement accounts untouched until you are actually retired, and to not look at them as an all-purpose piggy bank.

Read the original article on Investopedia.