When to use 401k to pay off debt?

After years of hard work, you might have accumulated a nice nest egg, and you may be tempted to use some of it to deal with the piling debts instead of leaving the money untouched for your retirement. While it is a bad idea to tap into your retirement savings, there are certain situations when it makes sense to use your 401(k) to pay off debt.

You can use a 401(k) to pay off high-interest debts like credit card loans since it can reduce the interest you pay. If you opt for a 401(k) loan, you can drastically reduce the interest rate from 15% - 20% to below 5%, and you will be paying the principal and interest to your 401(k). Also, if you are on the verge of default, a 401(k) can help you avoid further fees, penalties, and prevent further damage to your credit report and credit score.

Options for taking money out of 401(k) to pay debt

The two main ways you can use to access your 401(k) money include:

401(k) withdrawal

A 401(k) withdrawal takes money out of your retirement account permanently, and you are not required to pay back the money. However, you will owe income taxes on the withdrawn amount, and an additional 10% penalty if you are younger than 59 ½.

However, you may be exempted from paying the 10% penalty tax if you qualify for a hardship withdrawal. You may qualify for a hardship withdrawal if you are using the money to pay for qualified education expenses, pay medical bills, if you have become permanently disabled and unable to work, or when buying your primary residence. 

If you have mounting debts, you can decide to withdraw money from your 401(k) to pay high-interest debts. However, depending on your tax bracket, you could lose about 30% of the money to taxes. For example, if you withdrawal $30,000 to pay debts, and you are in the 20% tax bracket, you could owe $6,000 in income taxes and an extra $3,000 in early distribution penalty. Therefore, you risk losing $9,000 to taxes, remaining only with a balance of $21,000 to pay debts.

401(k) loan

If you have a 401(k) plan, you may be allowed to borrow against the accumulated retirement savings. You must pay back the loan over time, and you will make principal and interest payments back to your 401(k) account. Generally, the interest rate charged on a 401(k) loan is lower than traditional loans, and it is set a few points above the prime rate. If the prime rate is 3%, the 401(k) loan interest rate can go up to 5%.

If you want to avoid the stiff penalties associated with 401(k) withdrawals, you can use a 401(k) loan to pay debts. A 401(k) loan does not involve credit checks, and it won’t impact your credit score even if you miss a payment. You can borrow a maximum of $50,000 to pay debts, and you will be allowed up to 5 years to pay the loan. If you get a windfall distribution such as inheritance, you can make a lump sum payment to pay off the 401(k) loan, and you won’t be required to pay prepayment penalties.

A 401(k) loan is preferable to a withdrawal since you won't pay taxes and penalties on the loan amount. Using a 401(k) loan to pay off high-interest debts such as credit card debts can help you reduce the interest rates you pay to lenders. Also, once you pay off debts, you will be paying interest to your retirement account, which can help grow your retirement savings further.

When it makes sense to use 401(k) to pay off debt

Sometimes, it might make sense to use a 401(k) to pay off debt. For example, using a 401(k) loan to pay off debts with 15% to 20% interest could make sense, since you will be paying a lower interest on the 401(k) loan, mostly below 5%.

If you have upcoming debt payments and you have no way to pay them, taking money out of your 401(k) could help you avoid racking up more fees, penalties, and even dent your credit score.

In addition, if you are on the verge of defaulting on a loan, a 401(k) can help you avoid dire consequences such as court action, wage garnishment, or even losing the assets pledged as collateral. If loan payments and defaults appear on your credit card, it could affect your chances of getting a loan, getting a job, or even qualifying for a mortgage

Why using 401(k) to pay off debt is a bad idea

Any money taken out of your 401(k) misses out on both market gains and compound interest, and it can delay your retirement. Depending on how long it takes to repay the loan, you risk losing tens of thousands of dollars in growth over the loan term. Hence, this could mean that you have to wait longer to attain your retirement goals. This impact tends to be greater with age, and participants nearing retirement age take the biggest hit since it can be difficult to get the growth back and retire on time.