It may be tempting to tap your 401(k) retirement savings when you have pressing bills, such as high-interest credit card debt or multiple student loans. But while doing so can take care of current charges, you may well be short-changing your future. Early withdrawal of funds can involve fees and penalties, plus you are eating away at your nest egg.
Here’s a look at the pros and cons of using a loan or withdrawal from your 401(k) to pay off debt, along with some alternative options to consider.
Table of Contents
- What Are the Rules for 401(k) Withdrawal?
- Understanding 401(k) Withdrawal Taxes and Penalties
- Taking a 401(k) Loan to Pay Off Debt
- How Early 401(k) Withdrawals Can Impact Your Financial Future
- Alternatives to Cashing Out a 401(k) to Pay Off Debt
- What Are Some Ways of Minimizing Risks to Your Retirement?
- The Takeaway
Key Points
• Early 401(k) withdrawals typically incur a 10% penalty and are taxable.
• You typically need to repay a 401(k) loan, plus interest, within five years.
• Interest payments on a 401(k) loan benefit your retirement account.
• Both withdrawals and loans reduce long-term retirement savings and potential returns.
• Alternatives include 0% APR balance transfer cards, personal loans, and credit counseling.
What Are the Rules for 401(k) Withdrawal?
A 401(k) plan is designed to help you save for your retirement, so taking money out early usually isn’t easy — or cheap. Generally, you’re allowed to begin taking withdrawals penalty-free at age 59½. If you take money out before that age, the IRS typically imposes a 10% early withdrawal penalty.
If you’re 59 1/2 or older, you won’t have to pay the 10% penalty. However, the amount you withdraw 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 (and you’re at least 59½), however, you can withdraw funds tax-free.
đź’ˇ Quick Tip: With average interest rates lower than credit cards, a personal loan for credit card debt can substantially decrease your monthly bills.
Understanding 401(k) Withdrawal Taxes and Penalties
When you withdraw money from a traditional 401(k), the IRS considers it taxable income. That means you’ll owe income tax based on your tax bracket at the time of the withdrawal, plus a potential 10% penalty if you’re under the age threshold.
For example, let’s say you’re 33 years old and you have enough in your 401(k) to withdraw the $15,000 you need to pay off your credit card balance. You can expect to pay the 10% penalty, which will be $1,500. If you pay a tax rate of 22%, you can also expect to owe $3,300 in taxes. This will leave you with $10,200 to put towards your credit card debt.
Exceptions to Early Withdrawal Penalties
There are some exceptions to the 10% withdrawal penalty. You might be able to withdraw funds from a 401(k) without paying a penalty if you need the funds to cover:
• Emergency expenses
• Unreimbursed medical expenses over a certain amount
• Funeral expenses
• Birth or adoption expenses
• First-time home purchase
• Expenses and losses resulting from a federal declaration of disaster (subject to certain conditions)
Your 401(k) summary and plan description should state whether the plan allows early withdrawals in particular situations. Keep in mind that there may be a cap on how much you can withdraw penalty-free. Also, any withdrawal from a 401(k) is generally taxed as ordinary income.
Federal and State Tax Implications
If you make an early withdrawal from your 401(k), the amount is typically added to your gross income. As such, you will owe federal tax on the distribution at your normal effective tax rate. Depending on where you live, your withdrawal may also be subject to state income taxes.
Taking a 401(k) Loan to Pay Off Debt
If you’re looking to use a 401(k) to pay off debt, you may be able to avoid paying an early withdrawal penalty and taxes if you take the money out as a loan rather than a distribution.
A loan lets you borrow money from your 401(k) account and then pay it back to yourself over time. You’ll pay interest, but the interest and payments you make will go back into your retirement account.
Before going this route, however, you’ll want to make sure you understand the rules and regulations surrounding 401(k) loans:
• Depending on your employer, you could take out as much as half of your vested account balance or $50,000, whichever is less.
• You typically need to repay the borrowed funds, plus interest, within five years of taking your loan.
• You may need consent from your spouse/domestic partner before taking a 401(k) loan.
Here’s a look at the benefits and drawbacks of using a 401(k) loan to pay off debt:
Pros
• No tax or penalty if repaid on time: You won’t owe taxes or early withdrawal penalties as long as you follow the repayment schedule.
• You pay interest to yourself: The interest you pay on the loan goes back into your retirement plan account.
• No impacts to your credit: A 401(k) loan doesn’t require a hard credit inquiry, which can cause a small, temporary dip in your scores. And if you miss a payment or default on your loan, it won’t be reported to the credit bureaus.
Cons
• You may have to repay it quickly if you leave your job: If you leave or lose your job, the full outstanding loan balance may be due in a short period of time. If you can’t repay it, the IRS treats it as a distribution, meaning taxes and penalties may apply.
• Loss of investment growth: Money taken out of your 401(k) isn’t earning returns, which can hurt your long-term savings and future security.
• Borrowing limits: You might not be able to access as much cash as you need, particularly if you haven’t been saving for long. Typically, the maximum loan amount is $50,000 or 50% of your vested account balance, whichever is less.
How Early 401(k) Withdrawals Can Impact Your Financial Future
While paying off debt may feel urgent now, dipping into your 401(k) can have long-lasting effects on your retirement security.
Loss of Compound Growth
One of the most powerful benefits of a 401(k) is compound growth. Then is when your initial investment earns returns, then those returns are reinvested and also earn returns. “Compounding helps you to earn returns on your returns, which can help your earnings grow exponentially over time,” explains Brian Walsh, CFP® and Head of Advice & Planning at SoFi. The longer your money has to grow and compound, the more significant the impact of compounding becomes.
Reduced Retirement Readiness
Using your 401(k) to pay off debt means you’ll have less money later in life. When you withdraw or borrow from your account, you reduce the amount that’s working for you. Even a small early withdrawal can result in tens of thousands of dollars in lost retirement income over the decades.
For many Americans, retirement savings are already insufficient. Reducing your nest egg further could lead to delayed retirement or financial insecurity in your senior years.
Alternatives to Cashing Out a 401(k) to Pay Off Debt
Before tapping into retirement funds, consider exploring these less risky options for managing debt.
Balance Transfer Credit Cards
Some credit cards offer introductory 0% APR on balance transfers for a set period of time, often 12 to 21 months. If you qualify, this can give you a break from interest and allow you to pay off your balance faster. Just make sure you pay it off before the promotional period ends to avoid high interest rates.
Debt Consolidation Loans
If you have high-interest credit card debt, you might look into getting a ​​credit card consolidation loan. This is a type of personal loan that you use to pay off multiple credit card balances, combining them into a single loan with a potentially lower interest rate and a fixed monthly payment. This can simplify debt management and potentially save money on interest over time. Unlike 401(k) withdrawals, these loans won’t impact your retirement savings.
💡 Quick Tip: Before choosing a personal loan, ask about the lender’s fees: origination, prepayment, late fees, etc. One question can save you many dollars.
Credit Counseling Services
Nonprofit credit counseling agencies can help you develop a debt management plan, negotiate lower interest rates with creditors, and offer financial education. This approach may take longer, but it protects your retirement future and can help build good long-term financial habits.
Recommended: Debt Consolidation Calculator
What Are Some Ways of Minimizing Risks to Your Retirement?
If you decide using a 401(k) to pay off debt is your best (or only) option, here are a few things that could help you lower your financial risk.
Prioritizing High-Interest Debt Strategically
Consider taking the avalanche approach to paying off debt. This involves paying off debt with the highest interest rate first, while continuing to pay the minimum on your other debts. Once that highest-interest debt is paid off, you move on to the debt with the next-highest interest rate, and so on.
By focusing on the most expensive debt, you minimize the total interest paid over time, which can help you save money and get you out of debt faster.
Increasing Retirement Contributions Later
If you take a loan or withdrawal now, it’s wise to plan on increasing your 401(k) contributions once you’re in a better financial position. Many people underestimate their ability to “catch up” later, but making additional contributions, especially after age 50 (when catch-up contributions are allowed), can help rebuild your nest egg.
The Takeaway
Using a 401(k) loan or withdrawal to pay off debt may seem like an attractive option, especially when you’re feeling overwhelmed. But it’s a decision that shouldn’t be taken lightly. Early withdrawals generally come with taxes and penalties. And both withdrawals and loans remove money from your retirement account that is growing tax-free.
Instead of cashing out your future, consider alternative debt repayment strategies like balance transfer cards, credit counseling, or using a personal loan to pay off high-cost debt (ideally at a lower rate).
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.
FAQ
How much is the penalty for an early 401(k) withdrawal?
If you withdraw from your 401(k) before age 59½, you’ll typically face a 10% early withdrawal penalty on the amount taken out. Additionally, the withdrawn funds are considered taxable income, so you’ll owe federal — and possibly state — income taxes.
Can you take a loan from your 401(k)?
Yes, many 401(k) plans allow participants to take loans from their account. Typically, you can borrow up to 50% of your vested balance, up to a maximum of $50,000. The loan must usually be repaid with interest within five years.
While it’s convenient, taking a loan from your 401(k) can reduce your retirement savings and potential investment growth.
What are alternatives to a 401(k) withdrawal to pay off credit card debt?
Before tapping into your 401(k), it’s a good idea to consider options that won’t jeopardize your retirement savings. Alternatives include using a 0% APR balance transfer card or consolidating credit card debt with a personal loan, both of which can lower interest costs.
You could also negotiate lower interest rates or payment plans with creditors. Boosting income through side jobs or adjusting your budget to free up funds may help too. These options carry less financial risk and don’t incur early withdrawal penalties or taxes.
Does a 401(k) loan affect your credit score?
A 401(k) loan does not impact your credit score because it doesn’t require a credit check to obtain and the loan itself isn’t reported to credit bureaus. However, if you fail to repay the loan on time — especially after leaving your job — it may be treated as a taxable distribution, resulting in penalties and taxes. While that still won’t impact your credit, it can affect your financial health and future security.
What happens if you leave your job with an outstanding 401(k) loan?
If you leave your job with an unpaid 401(k) loan, the remaining balance is usually due quickly. If you don’t repay it in time, the unpaid amount is typically treated as a distribution, triggering income taxes and a 10% early withdrawal penalty if you’re under 59½. This can create a significant tax burden.
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