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.
- If you withdraw money from your 401(k) plan before age 59½, you’ll generally have to pay income tax plus a 10% penalty on the amount.
- After age 59½, you’ll just have to pay income tax, except with a Roth 401(k), which can be tax-free.
- Once you have withdrawn money from a 401(k), you can’t put it back.
- There are many alternatives to 401(k) withdrawals for repaying debt, including 401(k) loans.
The Rules on 401(k) Withdrawals
The rules on withdrawing money from your 401(k) plan depend on your age and the type of 401(k) you have: a traditional 401(k) or a Roth 401(k). They can also depend on what your particular plan allows.
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 and subject to both income tax and a 10% early withdrawal penalty. (There are some exceptions to the 10% penalty, if your plan allows them, known as hardship withdrawals. Those include withdrawals to pay medical bills, purchase a home, or cover qualified higher education expenses, or if you have become permanently and totally disabled.)
Suppose you take $45,000 from your 401(k) to pay off debt. For starters, you’ll face a $4,500 early withdrawal penalty. On top of that, you’ll also owe income tax on the $45,000. For example, if you’re single, and your other taxable income is $100,000, then your $45,000 withdrawal will be taxed at 24%, or $10,800 (as of 2021).
So, in total, your $45,000 withdrawal will cost you $15,300 and leave you with $29,700 to apply to your debts.
Withdrawals After Age 59½
Once you have reached age 59½, you 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 $45,000 withdrawal from your traditional 401(k) would cost you $10,800 in tax, leaving you with $34,200.
With a Roth 401(k), you would have the full $45,000 to pay off your debts.
Of course, with either type of 401(k), you would have that much less money saved for retirement.
When Paying Off Debt With Your 401(k) Makes Sense
Should You Use a 401(k) to Pay Off Debt?
In some cases, it could be beneficial to cash out a portion of your 401(k) to pay off a loan (or credit card) with an 18% to 20% interest rate, says Paul Palazzo, CFP, COA, managing director of financial planning at Altfest Personal Wealth Management.
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 $45,000 in retirement savings, plus their future earnings.
Fortunately, there are some alternatives.
A 401(k) loan, if your employer allows it, could be a better idea than a 401(k) withdrawal.
Alternative (Better) Ways to Reduce Debt
There are numerous ways to reduce your debts and the interest rates that you pay on them. Here are just a few:
- Negotiate your interest rate with your credit card company. If you have good credit, then you may be able to get your interest rate lowered by several percentage points.
- 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.
- 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.
- Take out a 401(k) loan instead of withdrawing the money.
“If a person has high-interest debt and is still working, I suggest looking at a 401(k) loan to pay off the debt,” says Wes Shannon, CFP, of SJK Financial Planning LLC. “Paying the loan back is paying interest to yourself into your account. So you go from paying others’ high interest to paying yourself a lower interest.”
Loans from a 401(k) plan have their own set of rules, of course. To begin with, your plan must permit them. If loans are allowed, they are limited to (a) the greater of $10,000 or 50% of your vested account balance, or (b) $50,000, whichever is less. 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, then you could have to repay your loan even sooner. Any amount you don’t repay can be subject to taxes and penalties just as if you had withdrawn the money.
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.
The Bottom Line
As a general rule, it’s always best to leave your retirement accounts untouched until you are actually retired and not to look on them as an all-purpose piggy bank.
“When you take money from your retirement account, it is easy to duplicate the action in the future. It is important to consider your retirement accounts off-limits until retirement. Sure, it is possible to withdraw the funds, but it is not wise,” says Kirk Chisholm, wealth manager at Innovative Advisory Group.