Is Using Your 401K to Pay Down Debt a Good Idea

You have debt. But you’ve also got a stash of cash in your 401(k).

If you’re feeling overwhelmed by high-interest credit card balances, a student loan, and/or an auto loan, you might think taking money out of your 401(k) is a good way to pay down that debt and get it under control.

But is withdrawing money from your 401(k) to pay off debt a good idea? How would you go about doing it — and then paying it back?

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 withdrawal removes money from your account permanently. You don’t pay the money back — but you can typically expect to pay taxes on the amount you withdraw. And, 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 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 like 401(k)s, 403(b)s, and others were designed to encourage workers to save for retirement, so the rules aren’t super friendly for those who want to make a withdrawal before age 59½.

But depending on your financial situation, 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, so it may be worth checking 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 you could draw on or some kind of insurance that will 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 expense requirements can be a little 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” for yourself, your spouse, your children, or your dependents. But you can’t expect to use a hardship distribution to repay a student loan from when you already attended college.

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

Even if you can qualify for a hardship distribution, it’s a good idea to plan to pay taxes on the distribution (which is generally treated as ordinary income). And, unless you meet specific criteria to qualify for a waiver , you’ll also pay a 10% early withdrawal penalty if you’re younger than 59½.

So, let’s say 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 even more. And if that added income bumps you into another tax bracket, you could end up paying even more.

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

Since compound interest creates the potential for your initial investment to grow significantly over time, 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.

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: though 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, typically, it will be considered ordinary income.

If you’re under age 59½ 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.

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.

•   Not using your high-interest credit cards once you use your 401(k) to pay them off. 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.

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

•   Not overborrowing. 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 card debt and you have to face those bills every month. 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. When it comes to things like student loans or auto loans, you might be able to get a lower interest rate than you’re currently paying.

This may be 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 20 to 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 (although 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 loans 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 may 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

It may not have ever crossed your mind, when you opened your 401(k), that you’d use it for anything other than retirement. And though it may be tempting to tap it now, especially if you’re facing a daunting amount of expensive debt, that’s a decision with both short- and long-term consequences. Before you use your 401(k) to pay off debt, you may want to consider other available alternatives. With a SoFi Personal Loan, for example, you might be able to get a do-over on that debt and a more manageable monthly payment.