You have debt. But, you’ve also got a stash of cash in your 401(k). If you’ve got things like credit card debt, a student loan, or an auto loan and you’re paying a high interest rate on your debt, you might think that taking money out of your 401(k) to pay down debt is a good idea.
After all, you likely feel overwhelmed just trying to get that debt under control. But is cashing out your 401(k) to pay off debt a good idea? And how would you go about doing it and then paying it back?
Can You Cash Out Your 401(k) to Pay Off Debt?
You might be happy to know that you can cash out all or part of your 401(k) to pay off debt, but there are strings attached. If you’re under 59 ½ years old, you will have to pay a 10% early withdrawal fee automatically.
On top of that, you will have to pay taxes on the amount that you take out.
If you’re trying to save money on interest by taking money out of your 401(k) to pay off debt, you’re probably not going to save much given how much extra you’ll have to pay just to access your money.
In addition, you may also face other ‘costs’ by taking money out of your 401(k) whether you’re over 59 ½ years old or not. After all, your 401(k) is meant to help you save money for retirement. So, if you are diverting money from it, you may have less when you retire.
That could end up being more than you realize, since compound interest can grow your initial investment significantly over time. (Compound interest is essentially when accrued interest is added to your original deposit, allowing interest to grow on top of interest.)
Every dollar you take out now could mean several dollars less in retirement. That can have a huge impact on your retirement plans and lifestyle that you need to consider before taking out the money.
Essentially, cashing out your 401(k) to pay off debt is like borrowing money from your future self, and since you can’t know the returns you would get on your invested money, you don’t know exactly how much money you’d be losing out on during retirement.
After all, it won’t just be the 5% in investment returns you might average annually (for example), but also the money you would have earned in the future on those investment returns.
Why Do People Do It?
Although there are significant costs involved in taking money out of a 401(k) to pay down debt, many people still do it. It can seem like a good option if you have high-interest debt like credit card debt.
If you’re paying well over 15% in interest on your current debt, you might not think that the early withdrawal fee is too high. You might believe that you’ll still save money on interest by paying off your debt early. But remember—you’ll still have to pay taxes on the money you take out as though it were income.
Also, if you have lower interest debt like student loans, personal loans, auto loans, or a home equity line of credit (HELOC), then the withdrawal penalty may be more of a deterrent.
So why do people do it? Unfortunately, some people may see cashing out their 401(k)s to pay off debt as their only option. If you have a debt payment due and no way to pay it, using your 401(k) to pay down debt might seem better than the credit risks of missing payments.
After all, late payments can rack up fees, interest, and can ding your credit score. If you default on a loan, that can have even more dire consequences, including court actions, and wage garnishment—depending on the loan and the lender. If your credit score ends up damaged due to late payments, that could also have a huge impact on your finances.
Having a damaged credit score could potentially make it more difficult to get loans in the future, including potentially having to pay a higher interest rate and maybe not being able to borrow as much.
That could add up to thousands of dollars in extra expenses that you would want to avoid—and using your 401(k) to pay down debt might seem like an attractive choice.
But before you call up your 401(k) issuer, know there are other options that could help you repay your debts without any of the penalties or taxes.
Alternatives to Taking Money Out of Your 401(k)
When it comes to paying down debt, your 401(k) really shouldn’t be the first place you look for relief. There are some solid alternatives to cashing out your 401(k) to pay off debt.
For example, you could check if you qualify to refinance your debt, and what rate you’re eligible for. When it comes to things like student loans or auto loans, you might be able to get a lower interest rate than you’re currently paying by refinancing your debt.
This can be especially true if your credit score or income have improved since you first took out your loan. If you took out your student loans when you were still a student, for example, you could be making more money now and might have built up a better credit history and therefore could be eligible for a better deal. .
If you have federal student loans and are still working towards that dream job (and salary), you could also look into income-driven repayment plans that limit the amount that you pay each month to 10% to 15% of your monthly discretionary income—which could help keep your monthly payments more manageable.
Many of these plans will also forgive any remaining balance on your federal student loans after 20 to 25 years of qualifying, on-time payments—something that you won’t be able to take advantage of if you pay off your loans with your 401(k).
If you still need help, you could look into whether you qualify to have your federal student loans put into forbearance or deferment (although you’ll want to consider these programs carefully, as you still may be responsible for any interest that accrues).
If you have credit card debt or other high interest debt, you could look into a credit card consolidation loan. Debt consolidation loans give you a new loan that’s designed to pay off your current loans or credit cards, ideally at a lower interest rate or with more favorable terms.
You can get these loans from a bank, credit union, or online lender— often by filling out a quick form and sending a few scanned documents. But it’s important to remember that this is still taking on debt, even if it’s debt on better terms for you.
One critical thing to remember when refinancing or consolidating debt is that you may have the option to extend the term of your loan.
Extending the loan’s term may reduce your monthly payments and free up some near-term cash flow.
But while extending the term of your loan means that you will likely pay more in interest over the life of your loan, that might be worthwhile to you to ensure that you have the capacity to cover your debt payments.
Looking at Other Options
Ultimately, while people are cashing out their 401(k) to pay off debt, it’s likely not the best way to repay your debt. Any of the options listed above could be a better choice than taking money out of their 401(k) to pay off your debt.
The alternatives presented in this post don’t have penalties for early withdrawals, and none should make you worry about a big tax bill later when your income taxes are due. Since you’re not taking money out of your retirement savings, you also won’t lose out on earning interest on your invested money.
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