When you have debt, it’s hard not to consider tapping your retirement savings. This is especially true if you’ve found your day-to-day finances upended by the pandemic—whether from job loss, reduced work hours, depleted emergency funds, or medical expenses.
So, should you use your 401(k) to pay off debt? The answer: It depends.
It’s wise to educate yourself about 401(k) loan rules and how they might impact you before you dip into retirement savings. That’s because using your 401(k) to pay off debt isn’t as straightforward as it seems, and another option might be better. Personal loans, for example, are specifically designed to help borrowers consolidate higher-interest debt.
Below we answer a few general questions about borrowing or withdrawing from your 401(k), and we explore other ways you can continue to save money while reducing debt.
Just remember to thoroughly review your specific 401(k) plan terms, too. That way, you can learn more about your unique situation and determine if using your 401(k) to pay off debt is right for you.
When it comes to cashing out your 401(k), there are generally two main ways to access funds: borrowing or withdrawing. Either way, the first step is to check with your plan administrator to learn about your options.
Then, compare them. Borrowing from your 401(k) requires repayment within a set payback period (typically five years), while withdrawing means taking money out of your 401(k)—or cashing it out altogether—with no intention of paying it back.
You might believe that borrowing or withdrawing from your 401(k) is a fast way to solve your debt problem. But keep in mind that there could be significant costs involved. In particular, you’ll want to be prepared for withdrawal penalties.
Don’t be surprised by 401(k) cash out penalties
For example, taking a withdrawal before age 59½ could result in a 10 percent early withdrawal penalty.
If you qualify for a 401(k) hardship withdrawal based on an “immediate and heavy financial need” as determined by the plan, you might be able to avoid the 10 percent penalty. But you should check your plan terms carefully to learn about the penalties and costs you might incur.
Also note that any money you take out could be taxed at your current tax rate, depending on the type of contributions made, which could negate some of the tax benefits you previously enjoyed.
Know your 401(k) loan rules before borrowing
When you borrow from your 401(k), you’ll eventually be paying yourself back. But don’t forget, you’ll be repaying the loan with after-tax dollars, which means you could miss out on certain tax advantages.
You’ll also have to adhere to a strict payback period, or you might be subject to early withdrawal penalties. In addition, if you leave or lose your job unexpectedly, you may need to pay back the full amount on a short timetable. The grace period generally lasts from your final day at work until you file taxes for that year.
What are the long-term effects of using 401(k) to pay off debt?
It’s always painful to accrue penalties and fees, especially if they’re avoidable. But using your 401(k) to pay off debt could also deprive you of long-term investment growth. After all, the longer your money is in your account, the more exposure you have to the markets and their potential gains.
And if your employer matches a percentage of your personal 401(k) contributions, and you stop them, you’ll miss out on those matching contributions.
Together, these losses could harm your future finances and jeopardize your long-term financial security.
Weighing all the options
While it might be tempting to draw from your 401(k), there might be more advantageous ways to both save and pay down debt. Here are some other strategies:
1. Create a budget that allows you to save and pay down debt
If you don’t have a written budget, now is the time to start. Putting it on paper will help you see exactly how much money you have coming in and how much is going out, which should include paying down debt as well as saving.
If you’re unsure how to allocate your income, consider the 50/30/20 rule, where 50 percent goes to your essentials, 30 percent to discretionary expenses (what we consider “wants” vs. “needs”), and 20 percent to savings. Just remember that a budget that’s too rigid can backfire; we all deserve a little fun in our lives.
2. Make savings automatic
You’ve probably heard the expression, “pay yourself first.” The best way to do that is to avoid seeing the money you want to save. Ask your HR department if you can divert a portion of your paycheck to a separate savings account.
You can set up that account as an emergency fund. If the money never hits your checking account, you’ll be less likely to spend it on day-to-day expenses. Plus, having a fund to tap for unexpected expenses can help lift you out of the debt cycle.
Another alternative to dipping into your 401(k) savings is to temporarily suspend your contributions—though it’s wise to try to save at least up to your company match, so you don’t forgo that “free money.”
3. Tackle existing debt: Snowball or avalanche
You’ll want a budget that will eliminate debt and its accompanying interest, and possibly still allow for the occasional splurge at your favorite restaurant.
There are two ways to do this: The “snowball” strategy, where you pay your smallest debt first, regardless of interest rate, while making minimum payments on the others. This approach is great for someone who feels inspired by the satisfaction of crossing things off a list.
The second strategy, “avalanche,” is where you make minimum payments on all your debts, but use any additional funds to make larger payments on the debt with the highest interest rate. Erasing those first could save more money in the long run.
4. Consider a personal loan
Sometimes, what’s most overwhelming about your debt is the sheer number of outstanding accounts, each with different payment terms. With a personal loan, you can consolidate your various higher-interest debts into one monthly payment with a fixed interest rate — and it’s often less than you were paying on the original debt. The money you save can then be used to further build your savings.
Consolidating your debts with a personal loan gives you a finite payment schedule and a light at the end of the tunnel: you’ll be able to see that your debt will be paid off, and when. Personal loans come with a variety of repayment schedules, so you can choose the amount you can comfortably pay each month and still allocate some funds to savings.
Moving towards a debt-free future
Debt might be a weight on your shoulders that you’d gladly get rid of, and at first glance, tapping your 401(k) might seem like an easy solution. But when you’re aware of all the other options available to you, you might be pleasantly surprised to know you can keep saving while paying down debt.
So don’t rule anything out before doing your research. By comparing your options, you can determine which actions work best for your situation. A deeper dive into how personal loans differ from 401(k) loans could help.Read about Personal Loans vs 401(k) Loans