If you’re struggling with debt, you may be tempted to use your retirement funds to help pay off outstanding balances. However, there may be penalties and taxes involved, along with other drawbacks.
Before using your 401(k) to pay debts, you’ll want to:
— Understand the implications of a 401(k) withdrawal.
— Be aware of emergency personal expense distributions.
— Know how a hardship withdrawal works.
— Consider a 401(k) loan.
— Decide which option is financially right for you.
Understand the Implications of a 401(k) Withdrawal
There could be consequences if you opt to cash out your 401(k) to pay off debt.
“Income tax and penalties significantly reduce how much you have to put toward your debt,” said Leslie H. Tayne, founder and debt management specialist at Tayne Law Group in New York City, in an email.
If you’re not yet 59 1/2 years old, you can expect to pay income tax on the amount withdrawn from a traditional 401(k), as well as a 10% penalty on the funds.
Suppose you withdraw $20,000 to pay off debt. If you pay a tax rate of 22%, you’ll owe $4,400 in taxes. Additionally, you’ll have to pay the 10% penalty of $2,000. This will leave you with $13,600 available to put toward debt.
If you’re age 59 1/2 or older, you won’t have to pay the 10% penalty. However, the amount withdrawn from a traditional 401(k) will still be taxed as income. If you have a Roth 401(k) and have held the account for at least five years, you will be able to take out funds tax-free.
Among the pros of a 401(k) withdrawal is that you won’t have to repay those funds. Taking money from your 401(k) can make sense when paying off high-interest debt, like credit cards, Tayne said.
On the downside, your retirement savings balance will drop. If you don’t have a plan to stay out of debt and build long-term savings, you could face financial struggles later.
[READ: How Much a 401(k) Early Withdrawal Costs]
Be Aware of Emergency Personal Expense Distributions
Starting in 2024, the SECURE 2.0 Act allows you to make a penalty-free distribution of up to $1,000 from your 401(k). You’ll need to repay the amount within three years. You’ll also have to self-certify that the money will be used to cover an emergency.
If you’re a victim of domestic abuse and not yet 59 1/2, you can take up to $10,000 or 50% of the account balance, whichever is less, from a 401(k) without paying a penalty.
Know How a Hardship Withdrawal Works
In some cases, you might be able to withdraw funds from a 401(k) to pay off debt without incurring extra fees. This is true if you qualify as having an immediate and heavy financial need, and meet IRS criteria. In those circumstances, you could take a hardship withdrawal.
You might be eligible for a hardship withdrawal if you:
— Have certain medical expenses.
— Need to pay funeral or burial costs.
— Purchase a home for the first time.
— Incur qualified educational fees.
— Must repair your home after a natural disaster.
Before you take a hardship withdrawal, check whether you are eligible. You may also want to consider the long-term effects of taking out that money. Cashing out your 401(k) could deplete the cushion for your retirement years.
[Reasons for a Retirement Hardship Withdrawal]
Consider a 401(k) Loan
Some 401(k) plans allow participants to take loans.
“If you take out a 401(k) loan, you’re borrowing from yourself,” Tayne said. As you make payments with interest, you’ll gradually replenish the account.
“Typically, you’ll have five years to repay the loan,” Tayne said. Generally, you’ll only be permitted to borrow up to 50% of your vested balance. If you have $80,000 as a vested balance, your loan amount could be up to $40,000.
One benefit of a 401(k) loan is that your credit score will not need to be checked.
“Taking out a loan from your retirement savings will not hurt your credit score,” said William Haight of Capital Choice Financial Group in Phoenix, in an email. “Any of the interest paid may be tax deductible if certain conditions are met.”
This could provide additional savings as you eliminate the debt. You may have some flexibility in deciding how much to pay back and the timeline for doing so.
“If you don’t repay as agreed, you’ll be subject to income tax and penalties,” Tayne said.
Leaving your job while you have an outstanding balance on a 401(k) will also have consequences. You might have to repay the balance within 60 days to avoid penalties and fees.
[Read: Is a 401(k) Worth It in 2024? Pros, Cons and Costs]
Decide Which Option Is Financially Right for You
If you take out a 401(k) loan, you’ll temporarily have fewer funds invested. In the case of withdrawals, the money will be fully cleared from the account and unable to grow over time. Consider other options to pay off debt that don’t include tapping 401(k) funds.
Alternatives to a 401(k) loan could include a balance transfer credit card. This type of card allows you to carry over balances from other credit cards and often includes a 0% introductory interest rate for a period. You could also consider a debt consolidation loan, which can combine multiple debts with high interest rates into one loan with a lower rate.
If possible, try reworking your current budget. Perhaps you can pause contributions to the retirement account and use that money to pay down debt. You might also look for ways to reduce other household expenses to free up cash to put toward your balances.
More from U.S. News
Ways to Save for Retirement Without a 401(k)
Ask a Financial Pro: My Retirement Savings Are Up. Should I Retire This Year?
How to Take Advantage of 401(k) Catch-Up Contributions
Should You Use Your 401(k) to Pay Off Debt? originally appeared on usnews.com
Update 03/20/24: This story was previously published at an earlier date and has been updated with new information.
