Should You Use Your 401(k) To Pay Off Debt?

Although 401(k) plans are financial vehicles designed to drive you to a comfortable retirement, they’re also pools of money that can help you in other ways before you retire.

Borrowing from your 401(k) plan is an option many account owners have if they need to pay off significant debt. All 401(k) plans include an option for early withdrawal of funds, and many also have an option of borrowing money from it. Sometimes, people find themselves in the financial position of needing a substantial amount of money before they retire and either no easy or inexpensive way of getting it.

Securing a loan from your 401(k) is borrowing from yourself. It comes with a few benefits. Fees are usually minimal, and interest rates are usually fair. If you take a loan from your 401(k), you gain access to your money without having to pay a penalty for that early access.

But there are also risks. Those include penalties if you can’t pay the money back and the fact that any money you take out can’t generate interest and dividends from investments. You can cost yourself money from your decision to borrow. You also don’t want to be paying off debt in retirement if you borrow the money late in your career.

What Are the Rules on 401(k) Withdrawals?

The rules that govern all 401(k) withdrawals start with those from the Internal Revenue Service. But each plan sponsor — your employer — can have its own special structure of regulations and guidelines that, once set, it must follow. That’s one way for the sponsor to ensure that every account owner gets treated indiscriminately.

Some 401(k) plans permit loans to participants, for example. Others don’t. Plans can also have differing vesting timelines for participants, which can also affect the timing of withdrawals.

Regardless, the cost of withdrawing money from any retirement-based account primarily depends on your age. The defining age for these accounts is 59½ years old. People who are younger are subject to higher withdrawal costs.

Withdrawals Before 59½

If you take money out of your 401(k) account before the age of 59½, you incur an automatic 10% penalty. Although 10% might not seem like much, it can be a big deal if you’re much younger than 59½. The younger you are, the more that penalty amount adds up as an opportunity cost.

The whole idea of saving for retirement at a young age is to get that money into a place where it can work for you in the background with nothing for you to do to help it grow. But any funds that come out of your account early are monies that won’t generate long-term gains for you between now and the day you retire. (Or until the day you need the money after you retire.)

Besides the 10% penalty, you’ll also get hit with a federal income tax from the withdrawal. That tax is immediate, deducted directly from the amount you borrow.

Withdrawals After 59½

If you’re 59½ or older, your age works to your advantage for taking money out of your 401(k) and other retirement accounts. The IRS doesn’t levy an automatic 10-percent penalty on these withdrawals. After all, according to the 401(k) regulations, this isn’t an early withdrawal.

However, the IRS will apply a 20% immediate tax on any money you withdraw.

The rules are different for Roth 401(k)s. If you have had money in a Roth 401(k) for at least five years, you can withdraw that money tax-free. (Any money placed in a Roth account comes from post-tax dollars.)

What Are Options for Taking Money Out of Your 401(k)?

You have two options for taking money out of your 401(k). You can make a withdrawal from the account, or you can borrow against the account.

A withdrawal is permanent. You can’t put the money back in.

A loan is temporary, up to five years. And you must pay the money back within five years.

Withdrawals

Withdrawing funds from your 401(k) is a serious decision, and it comes with tax consequences and earnings consequences. You’ll pay immediate income taxes on any money you withdraw, regardless of amount and regardless of your age. If you’re younger than 59½ years old, you’ll also get stuck with a 10% early withdrawal penalty.

» Learn More: Should You Withdraw From Your 401(k)?

401(k) Loan

If you think your financial pinch is a temporary solution and that soon you’ll be able to repay yourself the amount of money you need right now, consider a loan instead of a withdrawal. A 401(k) loan is like all other loans in that you have to pay it back, and you’ll have to pay interest on the total loan.

Two notes about the interest rate. When you take out a loan against your 401(k), your interest rate should be lower than the rate you could get from any other lender. The bad news: interest on a 401(k) loan isn’t tax deductible.

According to IRS regulations, all 401(k) loans have a five-year term. That means you repay yourself within that five-year span. The amount of the loan depends on your accumulated savings. Plans vary, but usually you can borrow up to the total amount.

One downside of a 401(k) loan is that you can limit yourself professionally. If you leave the company that sponsors the 401(k) plan you borrowed from, you pay back the remaining balance of the loan, usually within 90 days of leaving the company.

Should You Use A 401(k) To Pay Off Debt?

If you have a 401(k) plan, you can use it to pay off (or pay down) a debt. That’s not to say you should. In fact, most financial planners cringe at the notion of someone who isn’t close to retirement taking money out of their 401(k) for any reason. The financial hit that you get from penalties and taxes usually makes the debt-payment strategy not worth it.

There are a few situations where it makes sense to tap your 401(k) to get rid of personal debt. All of them fall into the category of hardship withdrawals, which are designated for “immediate and heavy” financial needs. Examples include:

• A down payment for buying a permanent residence
• Medical bills
• College tuition
• Funeral expenses
• Rent or mortgage payments to stave off an eviction
• Some home repairs

Notice what’s not on the list: paying off credit card debt or other personal debts such as vehicle loans.

According to Fidelity Investments, which manages the largest retirement plans in the country, only 2.2% of 401(k) owners made hardship withdrawals in the first three quarters of 2022. The rate for 2021 was only 1.9%.

But even though IRS regulations permit hardship withdrawals doesn’t mean that makes financial sense to do one. You must do the math — calculating penalties, taxes and opportunity costs — to make sure taking money out of your retirement plan is a smart play. The opportunity cost is how much money you would have made in 10, 20 or 30 years from now had you left the money invested in the account with a fair rate of return. Sometimes, the amount of money you stand to lose is enough to make you decide not to take money out of your 401(k).

Advantages

Sometimes it makes financial sense to borrow from your 401(k). Among the reasons are:

• If you have a high-interest debt, such as from a credit card with a big balance, you may get a much lower interest rate on a 401(k) loan.
• If you have upcoming debt payments and no other alternatives for paying them, borrowing from your 401(k) can reduce fees and penalties.
• If you’re about to default on a loan or go into bankruptcy, borrowing from your 401(k) can prevent court action, wage garnishment or asset repossession.
• If you’re about to miss credit card payments or loan payments. Borrowing from your 401(k) means could preserve your credit score.

Disadvantages and Risks

There are inherent disadvantages and risks of taking money out of a financial vehicle designed for long-term investment for an immediate gain. Among them are:

• If you’re younger than 59½, you will incur significant penalties and costs.
• Any money you take out of your 401(k) will miss out on stock market gains and compound interest. Those lost profits can delay your retirement.
• Many 401(k) loans have to be repaid within five years of the borrow date. If you leave the company that sponsors your 401(k) plan before you pay off your loan, the due date on that loan probably will come within 90 days after you leave the company.

Does Withdrawing from Your 401(k) Hurt Your Credit?

Withdrawing money from your 401(k) has no impact on your credit. You can do an early withdrawal or a loan, but neither affects your credit or credit score.  While the three credit reporting bureaus have access to just about everything in your financial world, they don’t have access to it all — and that includes your 401(k).

When Can You Withdraw From Your 401(k) Without Penalties?

Many 401(k) plans allow for hardship withdrawals, although they’re not required to do so. Plans that permit hardship withdrawals have a set criterion for what qualifies as a hardship. Any hardship withdrawal must stay within the financial framework of a defined hardship. That’s defined by the IRS as an “immediate and heavy financial need of the employee.”

Expenses that fall under the “immediate and heavy” category:

• Certain medical costs
• Payments for avoiding eviction from or foreclosure on a principal residence
• Expenses to pay for a major repair of a principal residence
• Expenses and losses from a natural disaster (hurricane, tornado, fire or flood) provided the principal residence fall within a disaster zone
• Down payments and costs to buy a principal residence
• Tuition and other related educational expenses
• Burial or funeral expenses

If you have access to money from a spouse or from children (even minor children), that often nullifies the “immediate and heavy” argument. Examples from the IRS include a second home, or a vacation home. If the employee owns one, it counts as an asset and won’t fall under the hardship rules. But money held in a trust for children won’t be considered an asset.

Working with a Nonprofit Credit Counselor

One alternative to borrowing from your 401(k) is having a professional financial expert help you navigate your options first. You can engage a non-profit credit counselor as someone who can look at your financial portfolio and suggest actions to get you the money you need while preserving your credit and your retirement savings.

Representatives for InCharge Debt Solutions provide free nonprofit credit counseling through an online chat or on the phone. They’ll help you navigate through various choices and help you understand the pros and cons of each one.