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The average American has $90,460 in debt. This high amount of debt can feel overwhelming. After all, debt is taxing—in more ways than one. Not only does debt typically come with interest payments and fees, but it can also take an emotional toll on your day-to-day life and stop you from taking advantage of new opportunities. As a result, people look for all kinds of ways to get out of debt faster. One popular question people ask themselves is, “Should I cash out my 401(k) to pay off debt?”
People may consider borrowing from their retirement fund to help pay down debt. However, it’s usually not the best money move to borrow from your 401(k) because there are various penalties and costs associated with it. Understanding these costs can help you make a more informed decision about whether pulling from your 401(k) is the right decision for you.
What happens if I withdraw money from my 401(k)?
A 401(k) is an employer-sponsored retirement plan. Before you consider withdrawing money from this plan, you’ll need to check that your employer allows withdrawals.
Next, understand that you’ll be charged early withdrawal penalties when you tap into your 401(k). Your withdrawal penalties will differ based on your age:
Withdrawing before age 59½
For individuals 59½ years old and younger, the early withdrawal penalty is 10 percent. You’ll also have to pay income tax on what you withdraw, which in 2021 can range from 10 to 37 percent.
Plus, the withdrawal can impact your income taxes in one other way. Making annual plan contributions to your 401(k) reduces your taxable income. So if you withdraw a significant amount from your 401(k) account, it could push you into a higher income tax bracket and you might owe more in taxes.
Let’s look at an example of what a withdrawal can potentially cost you when you’re 59½ years old or younger.
Say you take out $40,000 to pay off a high-interest credit card and a student loan. Right away, you’re charged the 10 percent penalty, which is $4,000. Next, you’ll owe income tax on that $40,000. If you’re a single-income earner who makes $40,000 in 2021, your annual salary is in the 12 percent income tax bracket. However, this $40,000 withdrawal will put you in the next bracket with a tax rate of 22 percent, which means an additional $8,800 of your withdrawal will go toward taxes.
So, that $40,000 you’re taking out will cost you $12,800 in taxes and fees, leaving you with $27,200 to apply to your debts.
Withdrawing after age 59½
If you’re withdrawing after age 59½, you won’t have to pay any early withdrawal penalty fee, but you’ll still have to pay income tax.
Using the example above, if you withdraw $40,000, you’ll have to pay the 22 percent income tax on it. This will cost you $8,800 and leave you with $31,200.
Exceptions to the withdrawal penalty
A few situations allow for exceptions to the withdrawal penalty, the most common being the hardship withdrawal. The early withdrawal penalty from a 401(k) can be waived if you prove and receive a need for “hardship distribution.” According to the IRS, you may qualify for a hardship withdrawal if:
- You have an immediate and heavy financial need
- You don’t withdraw more than is necessary to satisfy your financial need
Some examples of instances when someone might need a hardship withdrawal include paying rent to avoid eviction, covering your mortgage to prevent foreclosure, paying for medical bills, repairing your house after a natural disaster and paying for the funeral costs of a loved one. During the COVID-19 pandemic, the CARES Act made it possible for qualifying individuals impacted by the pandemic to withdraw from their 401(k) without incurring an early withdrawal penalty.
Pros and cons of using your 401(k) to pay off debt
Let’s take a look at the benefits and drawbacks of using your 401(k) to pay off debt:
Pros
- Paying off debt can decrease your stress levels.
- You can save money on debts with high interest rates (like credit card debt).
- When you pay off debt, you free up money to then save or invest in other ways.
Cons
- You might lose more money than you save in the long run.
- You’ll likely have high taxes and penalties to pay.
- You might find it harder to retire in the future.
- You’ll be losing out on the compound interest that could have been earned on the retirement savings.
What is a 401(k) loan?
Instead of a 401(k) withdrawal, you may consider opting for a 401(k) loan. As the name implies, a 401(k) loan means you need to pay the money back into your account in the future. Of course, for this to be an option, your employer has to allow 401(k) loans.
The terms of your 401(k) loan will vary depending on your employer. The IRS limits 401(k) loan amounts to (1) the greater of $10,000 or 50 percent of your vested account balance or (2) $50,000, whichever is less. So, if you have $40,000 in your 401(k) account, the maximum loan you could get is $20,000.
401(k) loans typically have a repayment term of five years, but they can be due earlier if you quit your job. If you don’t repay any part of the loan, the outstanding balance will be subject to penalties and fees.
Still, the clear benefit of a 401(k) loan versus a 401(k) withdrawal is that you’ll replenish your retirement account.
Other ways to pay off debt
It’s important to consider that tapping into your 401(k) isn’t the only way to pay off debt. Other options include:
- Balance transfer: If you have high-interest credit card debt, consider taking advantage of a balance transfer card. These cards charge a small fee but allow you to transfer an outstanding credit card balance to a new card. The new card often comes with a promotional period (usually six months to a year) in which you get a zero or extremely low interest rate. If you can take advantage of this promotional period, you’ll save hundreds or thousands in interest and make a significant dent in your debt.
- Debt consolidation: If you have outstanding debts with several lenders, you might want to consider debt consolidation. Debt consolidation involves paying off your existing creditors and leaving you with one large loan with one lender. This loan is often at a lower interest rate than the average of your old loans. Additionally, it makes tracking your debt much easier as you only have one bill to deal with.
- Negotiate your interest rate down: Consider negotiating with your lenders to get a lower interest rate, which can save you a lot of money as you pay off your debt. Note that this is more likely to be successful if you have a good credit score. The credit repair consultants at Lexington Law Firm can help you work on your credit.
- Review your budget: Consider reviewing your budget and looking for areas where you can decrease your spending. Changes like eliminating dining out, downsizing to one car for a household and canceling subscriptions can help you put more money toward debt.
The main takeaway here is that withdrawing money from your 401(k) is generally not recommended. The fees associated with this withdrawal are simply too high. Instead, it’s probably more beneficial to explore the other options available to you.
If a low credit score is preventing you from making progress in your financial health, consider getting help. At Lexington Law, our credit consultants will review your credit report and file disputes on your behalf for any inaccurate and unfair negative items. A strong credit score can help you secure better loan terms and lower interest rates in the future when you do need credit or loans.
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