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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.

Learning about the rules for withdrawing money from your 401(k) and the costs associated with deducting money in this way can help you make the right decision. Also valuable: Knowing some alternatives to 401(k) loans to pay off debt.

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.

When you make a 401(k) withdrawal, it 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. (You’ll learn more about these costs below.)

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.

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Understanding 401(k) Withdrawal 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.

Example: If you’re 33 years old, and you have enough in your 401(k) to withdraw the $20,000 you need to pay off an urgent credit card bill.

•   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 in taxes.

•   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.

Taking a Loan from Your 401(k)

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.

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.

But 401(k) loans have their own set of rules and costs, so you should be sure you know what you’re getting into. Also, depending on your employer, you could take out as much as half of your vested account balance or $50,000, whichever is less.
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Pros:

•   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.

Cons:

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

•   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

How Early 401(k) Withdrawals Can Impact Your Financial Future

Now that you know more about cashing out a 401(k) plan or taking a loan from your retirement account, also take a big picture view of what early withdrawals can mean.

•   On the plus side, you can potentially pay off a loan and escape the monthly payments that are costing you. For instance, the money could go toward a high-interest credit card debt, which could be a big relief and lower your money stress. It could take those monthly payments off the table and free up cash in your monthly budget.

•   However, on the downside, there’s more to consider other than the penalties and taxes. By taking money out of your retirement fund, you are losing the chance for this money to grow and provide for you in your later years. Compound interest creates the potential for your initial investment to increase 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. Even if you put back in the initial funds you had invested, you won’t have that long runway, time-wise, to recoup the growth.

Recommended: Using a Personal Loan to Pay Off Credit Card Debt

Alternatives to Cashing Out a 401(k) to Pay Off Debt

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.

•   Refinancing your student loan or auto loan can mean getting a lower interest rate than you’re currently paying. This can lower your monthly payments. Or you might extend the term of the loan, which is another way to lower the monthly payments.

However, if you have federal student loans, keep in mind that refinancing will mean you forfeit some benefits and protections, such as forbearance or deferment. Plus, if you refinance for a longer term, you are likely paying more in interest over the life of the loan.

•   If you have credit card debt or other high-interest debt, you could look into a credit card consolidation loan. Debt consolidation loans are personal loans that are designed to pay off your current loans or credit cards, ideally with lower monthly payments.

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. 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.

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.

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, such as a personal loan.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.

FAQ

How much is the penalty for an early 401(k) withdrawal?

If you withdraw funds from your 401(k) before age 59 ½, you will likely be assessed a 10% penalty, plus there may be fees involved and income tax due.

Can you take a loan from your 401(k)?

Your 401(k) plan may allow you to take a loan. This can be subject to fees and taxes, and, if you change jobs while you have the loan, the whole amount could become due.

What are alternatives to a 401(k) withdrawal to pay off credit card debt?

You might consider a personal loan (aka a debt consolidation loan) to help pay off the loan. You would look for a loan that offers for favorable terms than your card does to help you lower your monthly payment and get out of debt.

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*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SOPL-Q224-1940017-V1

You may be getting divorced, but you’re not alone. According to the U.S. Census Bureau, 34% of women and 33% of men in the United States are right there with you, having ended their unions.

Certainly, though, this life event can cause emotional turmoil, and it may trigger worries about money too. Take heart: The end of a marriage does not have to mean an end to financial security. If you keep calm and make a careful post-divorce budget, you are more likely to stay fiscally fit.

Why Is a Post-divorce Budget Critical?

A realistic budget after divorce is a must. It can often cost a lot more to run two households than one. Still, doing what’s right for your personal life path and well-being comes first; there’s no point staying unhappily wed simply to save money. It can be possible to find steady footing during this transition with the right basic living expenses budget.

Truth is, after the sometimes hefty expense of a divorce lawyer (if you hired one), you will possibly be solely responsible for housing, utilities, groceries, car maintenance, and more.

There are various ways to budget for this, including the 50/30/20 rule and the envelope system, among others. You’ll also likely encounter a variety of tools, including spreadsheets and apps. Take the time to review your options and find an approach that feels right for you.

Recommended: Am I Responsible for My Spouse’s Debt?

Lifestyle Pre-divorce and Post-divorce Will Be Different

Get ready for changes in your lifestyle and your cash management. Transitioning from couplehood to single status can take time, patience, and being kind to yourself.

You will likely need to set up your own bank account, for example, if you previously had a joint account with your ex. And you’ll need to put your place of residence, you car, and utility bills, among other things, in your name.

You may be responsible for more household chores now, as you may not be able to afford, say, the cleaning person or landscaper you used to employ. Trimming the leisure budget (dinners out, vacations, entertainment, fitness classes) might be necessary, but all is not lost. Prioritize what is most important to your self-care now. This can be a bump in the road, not the end of the line.

Newly Single Life Can Be Taxing Emotionally and Financially

Divorce can affect your spirit as well as your finances. If you’re struggling and don’t have a therapist, consider finding one and/or joining a support group in your community. We can’t always “adult” our way through rough times.

Finances for Children May Be Difficult

Children are a hot-button topic for almost all parents, both married and divorced. Meeting their emotional and financial needs can lead to a tug-of-war, especially if you and your ex don’t communicate calmly and effectively.

As your divorce unfolds, pay close attention to what counts as child support. For instance, you may want to continue your child’s soccer league, guitar lessons, or art classes, but these activities may or may not be covered. Also, if you have a teen who is begging for a used car, that large expenditure may not be covered by child support either.

Knowing just what counts as a child support expense, along with careful record keeping, will be important as you develop with your divorce budget. After all, knowledge is power. It will help you negotiate and budget better as a single parent, as well as keep the peace as you co-parent.

Recognize You Can No Longer Rely on Two Incomes

It can be a huge learning curve: Relying on a single salary instead of two. This post-divorce situation can be especially complicated if your ex had the employee benefits, including family health and dental insurance, 401(k) contributions, and a flexible spending account (FSA), where payroll deductions cover everything from child care to eyeglasses.

Now is the time to investigate what options you have to gain self-sufficiency and stay on budget. For example, if you work, does your employer offer an affordable health insurance plan? If you are self-employed, what networking groups could advise you on good options? Do you perhaps qualify for a lower-cost health insurance plan on the marketplace? Explore ways to save money, too. For instance, perhaps a high-yield savings account might be right for you. Even if you contribute just $20 a week, the money can add up and earn interest over time. Invest some time in seeing what’s available that suits your needs and budget.

Potential Questions to Ask Yourself

As you move through your divorce process and onto your newly single life, ask and answer the big questions. These can help you both trouble-shoot and thrive.

•   How much is my income going to change? First, look at past bank statements. See how much your spouse and you have each contributed to the family income. In many cases, of course, alimony will come into play, but you need a realistic income-based expectation for that, too.

•   What do I need to let go of? This may take soul-searching. As you go from two incomes to one income, it’s likely that something’s got to give in terms of expenditures. Think creatively about where and how to economize. You might decide to plan and cook ahead for the week to minimize the temptation and expense of eating out. Or perhaps you decide to split an apartment with a friend for a while to save on rent while you get your bearings. It’s your call.

•   How should I supplement my income? If you need to get cash flowing your way, contemplate what’s in your toolbox of strengths and skills. One of the key benefits of a side hustle is that it can boost your income and fit your schedule. Maybe you’re a super-organized person who offers decluttering skills, a tech-savvy type who can build websites for others, or an animal lover who pet-sits or walks dogs. Other ideas: Fill free hours as an Instacart shopper, Amazon delivery person, or Uber driver.

•   How will we fairly work out financial support for the kids? Are the children dividing their time 50/50 between you and your ex? What will your child support agreement entail? What additional expenses may come up in the future (tutoring, college prep classes)? Think and work it through, possibly with professional guidance.

Post-Divorce Budgeting Tips

Once you have mulled over the issues relating to post-divorce life, keep these strategies in mind to help you optimize your finances.

Focusing On Current Income

Base your budget on your income now, after taxes. Do not base it on the projected income you hope to have. Don’t get caught up thinking about your former two-person income. Being pragmatic right now will likely pay off and help you stay out of debt.

Focusing On Most Important Monthly Expenses

For now, prioritize what it will take to get through daily life. Calculate costs of a roof over your head, a way to get to work, food, child care, healthcare, and other essentials. Take care of people first, starting with yourself; then deal with material things later.

Letting Go of Unnecessary Items

Go ahead and slash some items out of your budget. There are some easy ways to save money. Perhaps you can jettison a couple of streaming services, cut back on clothes shopping, and mow your own lawn instead of hiring someone else to do it. That feeling of opening up some room in your budget can be priceless.

Giving Yourself Safe and Budget-Friendly Fun

Find the right mood lifters. Avoid expensive, impulsive purchases when you are feeling emotionally hurt and raw. They can wreak havoc with your finances.

Instead, treat yourself to free or low-cost adventures and experiences. Fresh air can be healing and motivating; local parks and wildlife sanctuaries may offer free guided walks and birdwatching outings.

Considering Working With a Financial Advisor

As you sort out your finances as you approach a divorce, you may want to enlist a professional versed in the issues that can crop up. Child support, shared credit-card debt, and division of jointly owned real estate can require this kind of guidance. A certified divorce financial analyst (CDFA) is trained to assist with this and help you get the fairest possible deal. Explore the possibility and find out the CDFA fees to see if it’s a good option for you.

Post-divorce, you might also seek out an advisor who can help you set up a financial plan so that your spending and saving habits suit your new situation.

The Takeaway

Transitioning from pre-divorce to post-divorce life can stir up fears and insecurities, but you can take concrete steps to manage the unknown. Face facts about income, set a realistic budget, and find the right bank account. Prioritize your needs, and be willing to put unnecessary expenses on hold for now. Like so many others, you will find your footing and peace of mind, thanks to patience, flexibility, and wise budgeting.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

FAQ

How do you budget after a divorce?

To budget for post-divorce life, assess and prioritize non-negotiable needs (such as housing, food, utilities, and child care), and phase out or reduce unnecessary extras. Pay attention to the details of your divorce agreement, as alimony and/or child support may impact your finances significantly.

How long does it take to financially recover from divorce?

The timeline for recovering financially from divorce varies tremendously, depending on the particulars of a person’s income, divorce agreement, and other factors. It may take around five years to fully regain your sense of control over your money, though that could happen much sooner (or take even longer) for some.

Will I be poor after divorce?

The U.S. Census Bureau reports that after a divorce, household income for women can drop considerably. This is all the more reason to budget carefully after divorce and seek professional advice. These steps could help you avoid costly mistakes that impact your financial wellness.

Photo credit: iStock/PeopleImages

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2024 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
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