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Using Your 401(k) to Pay Down Debt

By Kim Franke-Folstad · September 07, 2022 · 8 minute read

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Using Your 401(k) to Pay Down Debt

Let’s say you have debt from high-interest credit cards, a student loan, and a car loan. But you also have a stash of cash just sitting in your 401(k) plan. You might think that taking money out of your 401(k) is a smart way to pay down that debt or even pay it off completely.

But is using your 401(k) to pay off debt really a good idea? We’ll go over the rules around withdrawing money from your 401(k), the costs associated with loans, and how a loan can ultimately affect your retirement. Finally, we’ll offer some alternatives to 401(k) loans to pay off debt.

What Are Some Options for Taking Money Out of a 401(k)?

There are two basic options for taking money out of a 401(k): withdrawals and loans.

401(k) Withdrawal

A 401(k) withdrawal removes money from your account permanently — you don’t pay the money back. You should expect to pay taxes on the amount you withdraw. Depending on your age, you may have to pay an early withdrawal penalty as well.

401(k) Loan

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.

There are pros and cons for each of these options. And the rules can vary depending on your age and what your employer’s plan allows. Here are some things to consider.

What Are the Rules for 401(k) Withdrawal?

Tax-deferred retirement accounts, such as 401(k) plans and 403(b) plans, were designed to encourage workers to save for retirement. So the rules aren’t super friendly when it comes to withdrawals before age 59 ½.

Depending on your financial situation, however, you may be able to request what the IRS calls a hardship distribution. Employer retirement plans aren’t required to provide hardship distribution options to employees, but many do. Check with your HR department or plan administrator for details on what your plan allows.

According to the IRS, to qualify as a hardship, a 401(k) distribution must be made because of an “immediate and heavy financial need,” and the amount must be only what is necessary to satisfy this financial need. Expenses the IRS will automatically accept include:

•   Certain medical costs.

•   Costs related to buying a principal residence.

•   Tuition and related educational fees and expenses.

•   Payments necessary to avoid eviction or foreclosure.

•   Burial or funeral expenses.

•   Certain expenses to repair casualty losses to a principal residence (such as losses from a fire, earthquake, or flood).

You still may not qualify for a hardship withdrawal, however, if you have other assets to draw on or insurance that could cover your needs. And your employer may require documentation to back up your request.

You probably noticed that credit card and auto loan payments aren’t included on the IRS list. And even the tuition requirements can be tricky. You can ask for a hardship distribution to pay for tuition, related educational fees, and room and board expenses “for up to the next 12 months of post-secondary education.” The student can be yourself, your spouse, your child, or another dependent. But you can’t use a hardship distribution to repay a student loan from when you attended college.

Recommended: How Does a 401(k) Hardship Withdrawal Work?

Are 401(k) Withdrawals Subject to Taxes and Penalties?

Even if you can qualify for a hardship distribution, plan on paying taxes on the distribution (which is generally treated as ordinary income). Unless you meet specific criteria to qualify for a waiver, you’ll also pay a 10% early withdrawal penalty if you’re younger than 59 ½.

Now let’s assume you’re 33 years old, and you have enough in your 401(k) to withdraw the $20,000 you need. Right off the top, unless you qualify for a waiver, you can expect to pay a $2,000 early withdrawal penalty. Then, when you file your income tax return, that 401(k) distribution will most likely be counted as ordinary income, so it will cost you another 25% or so. If the added income bumps you into another tax bracket, your tax bill could be higher.

But taxes and penalties aren’t the only costs to consider when you’re deciding whether to go the distribution route.

Compound interest creates the potential for your initial investment to grow significantly over time. So every dollar you take out now could mean several dollars less in retirement. Essentially, withdrawing from your 401(k) now is like borrowing money from your future self, because you’re losing long-term growth.

Recommended: 401(k) Early Withdrawal Penalties Explained

What Are the Costs Associated With 401(k) Loans?

You may be able to avoid paying an early withdrawal penalty and taxes if you borrow from your 401(k) instead of taking the money as a distribution. But 401(k) loans have their own set of rules and costs, so you should be sure you know what you’re getting into.

There are some appealing advantages to borrowing from a 401(k). For starters, if your plan offers loans (not all do), you might qualify based only on your participation in the plan. There won’t be a credit check or any impact to your credit score — even if you miss a payment. And borrowers generally have five years to pay back a 401(k) loan.

Another plus: Although you’ll have to pay interest (usually one or two points above the prime rate), the interest will go back into your own 401(k) account — not to a lender as it would with a typical loan.

You may have to pay an application fee and/or maintenance fee, however, which will reduce your account balance.

Of course, a potentially more impactful cost to consider is how borrowing a large sum from your 401(k) now could affect your lifestyle in retirement. Even though your outstanding balance will be earning interest, you’ll be the one paying that interest.

Until you pay the money back, you’ll lose out on any market gains you might have had — and you’ll miss out on increasing your savings with the power of compound interest. If you reduce your 401(k) contributions while you’re making loan payments, you’ll further diminish your account’s potential growth.

Another risk to consider is that you might decide to leave your job before the loan is repaid. According to IRS regulations, you must repay whatever you still owe on your 401(k) loan within 60 days of leaving your employer. If you fail to pay off the outstanding balance in that time, it will be considered a distribution from your plan. And when tax time rolls around, you’ll have to include that amount on your federal and state tax returns, where it will be considered ordinary income.

If you’re under age 59 ½ and the loan balance becomes a distribution, you may also have to pay a 10% early withdrawal penalty. There may be similar consequences if you default on a 401(k) loan.

Recommended: Pros & Cons of Using Retirement Funds to Pay for College

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.

•   Stop using your high-interest credit cards. If you continue to use your credit cards, and then have credit cards and the 401(k) loan payments to make every month, you could end up in even more financial trouble.

•   Continue to make contributions to your 401(k) while you’re repaying the loan — at least enough to get your employer’s match.

•   Don’t overborrow. Creating a budget could help you determine how much you can comfortably pay each quarter while staying on track with other goals. And try to stick to taking only the amount you really need to dump your debt and no more.

Why Do People Use Their 401(k) To Pay Down Debt?

Although there are significant costs involved in taking money out of a 401(k) to pay debt, many people still do it. It can seem like a good option if you have high-interest debt like credit cards. If you have lower interest debt like student loans, personal loans, auto loans, or a home equity line of credit (HELOC), then the early withdrawal penalty and other consequences may be a deterrent.

But if you’re paying high interest on your current debt, or if you have debt payments due and no way to cover them, using your 401(k) might seem better than the risks of missing payments on those bills. Late payments can rack up fees, interest, and can ding your credit score.

And if you default on a debt, that can have even more dire consequences, potentially including court actions and wage garnishment — depending on the type of debt and the creditor or lender. You can’t exactly wait it out and count on winning the lottery or inheriting money from some long-lost relative.

If your credit score ends up damaged due to late payments, that, too, could have a huge impact on your finances. Having a low credit score can make it more difficult to get loans in the future. You might have to pay a higher interest rate or there might be limits on how much you can borrow.

Given the dire consequences of doing nothing, using your 401(k) to pay off debt might seem like an attractive choice. But before you contact your HR department or plan administrator to request a loan or withdrawal, you may want to take time to look at some other options that could help you repay your debts.

What Are Some Alternatives to Taking Money Out of Your 401(k)

When it comes to paying down debt, your 401(k) isn’t the first or only place you can look for relief. There are some solid alternatives.

For example, refinancing your debt might be an option. Refinancing your student loan or auto loan can mean getting a lower interest rate than you’re currently paying. This is especially true if your credit score or income has improved since you first took out your loan. If you took out educational loans when you were still a student, for example, you’re likely making more money now and might have built up a credit history that could make you eligible for a better deal.

If you have federal student loans and are still working toward that dream job (and salary), you could look into income-driven repayment plans that limit the amount that you pay each month to a certain percentage 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 10, 20, or 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. (You’ll want to consider these programs carefully, as you may still 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 are 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 with different terms.

One critical thing to remember when using a personal loan to refinance or consolidate debt is that you may have the option to extend the length of your loan, which can reduce your monthly payments and free up some near-term cash flow.

While extending your loan term means you’ll likely pay more in interest over the life of your loan, it might be a worthwhile move to ensure you can cover your debt payments.

The Takeaway

While using your 401(k) to pay down debt is possible, it’s often not the best financial move you can make. That’s because 401(k) withdrawals often come with taxes and penalties that can eat up a third of your loan amount. Taking a loan from your 401(k) has its own disadvantages, including interest charges and strict repayment rules if you leave your job. But the most compelling reason is the effect that withdrawing retirement savings will have on your future lifestyle: Because of compounding interest, every dollar you withdraw results in several dollars of lost investment gains.

Before you use your 401(k) to pay off debt, consider other available alternatives. With a SoFi Personal Loan, for example, qualified applicants can get a low fixed interest rate. And there are no fees. Check your rate in 60 seconds without affecting your credit score.âśť

SoFi’s Personal Loan was named NerdWallet’s 2022 winner for Best Online Personal Loan.


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If you are looking to refinance federal student loans, please be aware that the White House has announced up to $20,000 of student loan forgiveness for Pell Grant recipients and $10,000 for qualifying borrowers whose student loans are federally held. Additionally, the federal student loan payment pause and interest holiday has been extended beyond December 31, 2022. Please carefully consider these changes before refinancing federally held loans with SoFi, since the amount or portion of your federal student debt that you refinance will no longer qualify for the federal loan payment suspension, interest waiver, or any other current or future benefits applicable to federal loans. If you qualify for federal student loan forgiveness and still wish to refinance, leave unrefinanced the amount you expect to be forgiven to receive your federal benefit.

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