When Paying Off Debt With Your 401(K) Makes Sense

By Reyna Gobel AAA

The average college student graduates with over $20,000 in student loan debt and over one million graduates are saddled with over $40,000 in debt. With the numbers that high, it's tempting to withdraw 401(k) plan funds that seem to be sitting and collecting dust until retirement. But before you drain your 401(k) account, you'll need to know if you are eligible, and if the cost in taxes and reduced funds at retirement will end up worth it.

Determining Withdrawal Eligibility
In most cases, you can only withdraw elective-deferral contributions, the deposits you made beyond what your employer deposited into your 401(k) plan. All of the money your employer deposited into your account is ineligible for distribution for debt repayment, says IRS representative Clay Sanford.

You can't withdraw these funds because your employer contributed the money for the sole purpose of your retirement. However, you may be able to withdraw money for early retirement in such cases as a layoff. (If you're self-employed, make sure you read Independent 401(K): A Top Retirement Vehicle For Sole Proprietors.) Depending on the conditions of your plan, you may not be able to withdraw money from your 401(k) at all or only in hardship situations such as for tuition or fees, significant medical expenses, purchasing a home, to prevent foreclosure or eviction, or necessary home repairs. Debt may be considered an eligible hardship case if it is allowed by your plan.

Tax Penalties for Withdrawing Money Early
If you withdraw from your retirement account early, you'll have to pay ordinary income tax plus a 10% tax penalty. For instance, if you take out $45,000 in elective-deferral contributions to pay off debt, you can instantly count on paying $4,500 in early withdrawal penalty. Then, since your 401(k) contribution was made tax free, you now have to pay federal income tax on this rate. For instance, in 2010 if you're single and your taxable income is $40,000, your marginal tax rate is 25%. However, the additional $45,000 in 401(k) distributions puts you into a higher tax bracket. Your income above $82,400 income will be taxed at a rate of 28%.

Granted, if you didn't deposit the money into your 401(k), you would have had to pay tax on it anyways. But you wouldn't have faced a one-year period where you'd have to pay the taxes all at once, and you likely wouldn't have had to pay the higher tax rate on it.

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When Cashing Out Make Sense
In some cases, it could be beneficial to cash out a portion of your 401(k) to pay off a loan with an 18-20% interest rate, says Paul Palazzo, CFP®, COA Managing Director of Financial Planning Altfest Personal Wealth Management. Make sure you've calculated interest costs versus tax penalties before deciding it is a good idea to withdraw money from you 401(k).

For the examples, we'll use the $45,000 and the $15,828 tax penalty.

Example 1:
You contemplate taking out $45,000 from your 401(k) to pay off credit cards with an average interest rate of 20%. You're thinking about this because of the high interest rate - you're barely able to make the payments - and you're worried about an increase in your interest rate if you miss a payment due to the strain on your budget.

Is the tax penalty worth it?

If this debt was paid off in 10 years, you would equalize the tax penalty in interest saved on the $45,000 in credit card debt in one year's time. Based on a comparison of tax penalty and interest rate this could be a good idea. However, you are also $45,000 short in your retirement account from what you had before.

The caveat is that it's a one-time occurrence, and you have a savings plan in place to repay the money plus interest earned. With a 3.25% interest rate in a savings account, $45,000 would grow to just under $62,000 in 10 years.

Example 2:
You have $45,000 in federal student loan debt consolidated for 25 years at a 6% fixed interest rate. You can afford your $290 payment, but you're worried about being able to afford it in the future. Regardless of the length of time it will take for your tax penalty to be repaid, taking out money from your 401(k) won't make sense. Why? With federal student loan debt, your interest rate will never rise above your fixed rate. You may qualify for temporary reprieves from payments or a less expensive payment plan if you struggle financially in the future.

Alternative Methods to Reduce Debt

There are numerous options to reduce debt and interest rates. Here are just a few:

  • Negotiate your interest rate with your credit card company. If you have good credit, you could get your interest dropped by several percentage points.
  • Make extra payments to reduce interest charged and loan length.
  • Transfer balances to a lower interest credit cards.
  • If you have private student loans, consolidate your loans with a better rate if your credit has improved since the initial borrowing date.
  • Acquire a 401(k) loan instead of withdrawing money. (For more on 401(k) loans, check out Sometimes It Pays To Borrow From Your 401(k).)

The Bottom Line
There's an emotional effect that kicks in when you begin to view your 401(k) as accessible money. The amount you are eligible to withdraw is viewed as an extra bank account rather than your retirement nest egg. For instance, let's say you withdraw from your 401(k) earnings to pay off your credit cards. A few years later your credit cards have rebuilt themselves and you think about your 401(k) money sitting around collecting dust for 30 years. You take another withdrawal. A year later, you take out money for a home down payment. Before you know it, you're 65 with little saved for retirement.

While your debt may have seemed insurmountable, can you afford to pay the taxes on your distributions in one year? While withdrawing from your 401(k) can be one option, you will want to consider your long-term goals. Your 401(k) may or may not be better off collecting dust now, but treat the decision to withdraw money as if your future financial health depends on it. (To learn more, see our 401(k) And Qualified Plans Tutorial.)

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