If you’re struggling to make payments on outstanding balances, you might consider using funds you’ve put aside for retirement to get rid of the debt.
Taking from your 401(k) account could help you reduce or eliminate what you owe. However, there may be penalties and taxes involved, along with other drawbacks.
Before using your 401(k) to pay off debt, you’ll want to:
— Understand the implications of a 401(k) withdrawal.
— Know how a hardship withdrawal works.
— Consider a 401(k) loan.
— Decide which option is financially right for you.
[READ: 10 Strategies to Maximize Your 401(k) Balance.]
Understand the Implications of a 401(K) Withdrawal
If you opt to cash out your 401(k) to pay off debt, there could be implications.
“Income tax and penalties significantly reduce how much you have to put toward your debt,” says Leslie H. Tayne, Esq., founder and head attorney specializing in consumer and business debt at Tayne Law Group in New York City.
If you’re not yet 59 1/2 years old, you can expect to pay income tax on the amount withdrawn from a traditional 401(k), as well as a 10% penalty on the funds.
Suppose you withdraw $20,000 to pay off debt. If your income tax rate is 22%, you’ll owe $4,400 in taxes. Additionally, you’ll have to pay the 10% penalty of $2,000. This will leave you with $13,600 available to put toward debt.
If you’re age 59 1/2 or older, you won’t have to pay the 10% penalty. However, the amount withdrawn from a traditional 401(k) will still be taxed as income. If you have a Roth 401(k) and have held the account for at least five years, you will be able to take out funds tax-free.
Among the pros of a 401(k) withdrawal is that you won’t have to repay those funds. Taking money from your 401(k) “can make sense to use funds to pay off high-interest debt, like credit cards,” Tayne says.
On the downside, your retirement savings balance will drop. If you don’t have a plan to stay out of debt and build long-term savings, you could face financial struggles later.
Know How a Hardship Withdrawal Works
In some cases, you might be able to withdraw funds from a 401(k) to pay off debt without incurring extra fees. This is true if you qualify as having an “immediate and heavy financial need,” and meet IRS criteria. In those circumstances, you could take a hardship withdrawal.
You might be eligible for a hardship withdrawal if you:
— Have certain medical expenses.
— Need to pay funeral or burial costs.
— Purchase a home for the first time.
— Incur educational fees that qualify.
— Must repair your home after a natural disaster.
In recent years, a growing number of Americans have taken hardship withdrawals. This could coincide with rising inflation and cost of living. Job losses and the need to pay for uncovered health care expenses could also be factors.
Before you take a hardship withdrawal, check if you are eligible. You may also want to consider the long-term effects of taking out that money. Cashing out your 401(k) could deplete the cushion for your retirement years.
[READ: 6 Common Retirement Goals.]
Consider a 401(K) Loan
Some 401(k) plans allow for a loan.
“If you take out a 401(k) loan, you’re borrowing from yourself,” Tayne says. As you make payments with interest, you’ll gradually replenish the account.
“Typically, you’ll have five years to repay the loan,” Tayne says. Generally, you’ll only be permitted to borrow up to 50% of your vested balance. If you have $80,000 as a vested balance, your loan amount could be up to $40,000.
One benefit of a 401(k) loan is that your credit score will not need to be checked.
“Taking out a loan from your retirement savings will not hurt your credit score,” says William Haight of Capital Choice Financial Group in Phoenix, Arizona. “Any of the interest paid may be tax deductible if certain conditions are met.”
This could provide additional savings as you get rid of the debt. You may have some flexibility in deciding how much to pay back and the timeline for doing so.
“If you don’t repay as agreed, you’ll be subject to income tax and penalties,” Tayne says.
Leaving your job while you have an outstanding balance on a 401(k) will also have consequences. You might have to repay the balance within 60 days to avoid penalties and fees.
Decide Which Option Is Financially Right for You
If you take out a 401(k) loan, you’ll temporarily have fewer funds invested. In the case of withdrawals, the money will be fully cleared from the account and unable to grow over time.
“This is generally not a preferred option, as the money in the retirement plan is, after all, designated for life in retirement years,” says Sean Fox, president of Achieve Resolution in San Mateo, California.
There could also be other ways to pay off debt that don’t include tapping 401(k) funds.
“In general, it’s a good idea to look into other options first,” Fox says.
You might consider reworking your current budget. Perhaps you can pause contributions to the retirement account and use that money to pay down debt. You might also look for ways to reduce other household expenses to free up cash to put toward your balances.
Alternatives to a 401(k) loan could include a balance transfer credit card. This type of card allows you to bring over balances from other credit cards, and often includes a 0% introductory interest rate for a period. You could also consider a debt consolidation loan, which can combine multiple debts at high interest rates into one loan with a lower rate.
If you create a financial roadmap, you could follow the plan to become debt free. By not touching the 401(k) funds, you’ll have a nest egg ready to support your retirement.
[Read: A Guide to 401(k) Vesting.]
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Should You Use Your 401(k) to Pay Off Debt? originally appeared on usnews.com
Correction 03/29/23: A previous version of this story misspelled the name of the firm where William Haight works.
