It can be hard for many consumers not to look longingly at their retirement savings. This is especially true if they have found their day-to-day finances upended by the pandemic — whether from job loss, reduced work hours, depleted emergency funds or medical emergencies that racked up mounting bills. If you have experienced financial hardship, you may be wondering: Should I use my 401(k) to pay off debt? It depends.
Using your 401(k) to pay off debt may not be as straightforward as it appears. Before you make this move, there are some important 401(k) loan rules to consider. Below, we answer a few general questions about borrowing or withdrawing from your 401(k), as well as discuss additional options that allow you to simultaneously reach your financial goals of saving money while reducing debt. You should review your 401(k) plan terms to learn more about your specific options and determine if using your 401(k) to pay off debt is right for you .
Is there a 401(k) withdrawal penalty?
If you’re wondering how to cash 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 sponsor to make sure learn what options are available to you.
Then, weigh your options to determine if borrowing or withdrawing funds works for your financial situation: Borrowing from your 401(k) requires repayment, within a set payback period (typically five years). Withdrawing, however, means you withdraw a certain amount of money or cash out your 401(k) with no intention of paying it back.
While using 401(k) to pay off debt might seem like a quick way to solve the issue, there are some accompanying costs that might surprise you. For example:
401(k) withdrawal penalties
Taking this route means you may accumulate penalties and fees. For example, taking a withdrawal before age 59½ may 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 may be able to avoid the 10 percent penalty. You should check your plan terms to determine what penalties and costs you may occur for certain distributions.
Please note, the money may taxed at your current tax rate, depending on the type of contributions made, negating potential tax benefits you may have previously enjoyed.
401(k) loan rules
When you borrow from your 401(k), you’ll eventually be paying yourself back. However, it’s important to remember you’ll be repaying the loan with after-tax dollars, which means you may be missing out on certain tax advantages.
You will have to adhere to a strict payback period or you may be subject to early withdrawal penalties associated with the loan. In addition, if you leave or lose your job unexpectedly, you may need to pay back the full amount on a short timetable. In general, the grace period lasts from your final day until you file taxes for the year in which you left your job.
What are the long-term effects of using 401(k) to pay off debt?
While avoidable penalties and fees are painful, another issue is that you may deprive yourself of long-term growth if you borrow or withdraw from your 401(k).
You may miss out on potential investment growth if you take money out of your 401(k). The longer your money is in your account, the more exposure you have to market experience and potential gains.
And if your employer matches a percentage of your personal 401(k) contributions and you stop contributions, you may be missing out on those matching contributions.
Together, these may cause harm to your future finances and jeopardize your long-term financial security.
Best practices in paying down debt while still saving
While it might be tempting to draw from a mass of money that appears to be just sitting there, there may be more advantageous tools in your financial kit that might allow you to both save and pay down your debt. Here are some strategies to consider:
1. Create a budget that addresses both needs
If you don’t have a written budget, now is the time to start. A practical approach can help you see exactly how much money you have coming in and how much is going out for fixed costs, 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, 20 percent to savings, and 30 percent to discretionary expenses — what we consider “wants” vs. “needs.” Just remember that a budget that’s too rigid can backfire; we all deserve a little fun in our lives from a splurge now and then.
2. Make savings automatic
You’ve probably heard the expression, “pay yourself first.” The best way to do that is to avoid ever seeing that 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 specifically for an emergency fund. If the money never hits your checking account, it’s less likely you’ll inadvertently spend it on day-to-day bills. Plus, having a fund to tap for unexpected expenses can help lift you out of the debt cycle.
Another alternative to withdrawing or borrowing from your 401(k) plan is to temporarily suspend your contributions, although it’s wise to try to save at least up to your company match, if possible, so you don’t forgo that “free money.”
3. Tackle existing debt in the way that suits your style
You’ll want a plan to eliminate that debt and the accompanying interest and maybe still allows for the occasional spurge at your favorite restaurant. There are two main ways to go about paying off debt; the first often referred to as 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 style is called an “avalanche,” 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 can potentially 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 that has a fixed interest rate — often less than you might the original debt. The money you save by not paying interest can then be used to further build your savings.
Consolidating your debts with a personal loan gives you a finite payment schedule that becomes a light at the end of the tunnel, assuring you that your debt will indeed eventually be paid off. Personal loans come with a variety of different lengths and schedules, so you can choose the amount you feel you can comfortably afford to pay off each month, perhaps making sure to keep allocating some funds toward your savings goals.
Debt can be a weight on your shoulders and one you may be inclined to remove with what appears to be an easy solution of tapping your 401(k). But when you consider other options, you might be pleasantly surprised at your ability to keep saving while still paying down your debt.
Wondering how much you might save in interest by consolidating higher interest loans into a personal loan? Use our debt consolidation calculator to get your debt management plan moving. Estimate Your Savings