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.
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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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