If you want to pay off debt, you might be asking yourself, “Can I use my 401(k) to pay off debt?” The quick answer is that you can, but you should first review the rules and potential financial impacts.
You might also want to consider some lower-risk alternatives to help you tackle your debt like budgeting changes, repayment strategies, or a debt consolidation loan. It also never hurts to consult with a financial advisor or tax professional.
Here are some important questions to consider before making a 401(k) withdrawal to pay off debt.
Table of contents
- What's a 401(k) withdrawal?
- Will I be penalized if I cash out my 401(k)?
- What is the difference between borrowing and withdrawing from my 401(k)?
- What are the long-term effects of using my 401(k) to pay off debt?
- What are some other ways to pay down my debt?
- How can I move towards a debt-free future?
What's a 401(k) withdrawal?
Withdrawing a portion of your 401(k)—or cashing it out altogether—means you’re taking money out of your account with no commitment to pay it back. This may seem like an easy way to tackle your debt, but be careful. Cashing out your 401(k) might leave you less money for retirement. In addition, there may be big costs involved, specifically higher taxes and early withdrawal penalties.
Will I be penalized if I cash out my 401(k)?
Yes, depending on your circumstances, you could be penalized if you cash out your 401(k). Taking a withdrawal before age 59½ may result in a 10% early-withdrawal penalty. It may also increase your tax burden for the year.
Traditional 401(k) withdrawals are usually taxed at your current tax rate. Depending on the type of contributions made, this may cancel out some of the tax benefits you previously enjoyed.
What reasons can you withdraw from a 401(k) without penalty?
If you are facing medical, funeral, tuition, or other education-related expenses, you may qualify for a 401(k) hardship withdrawal based on an “immediate and heavy financial need.” If eligible, you may avoid a penalty. Although you could avoid a penalty, you may still have tax consequences, so be sure to check your plan terms carefully. And it is always important to check with an accountant or tax specialist to learn more before making any decisions of this kind.
What is the difference between borrowing and withdrawing from my 401(k)?
If you do decide to use your 401(k) to help pay your debt or expenses, withdrawing your money is not the only option. You might also consider borrowing from it. Whether you are thinking of withdrawing or borrowing, the first step is to check with your plan administrator to learn about your options.
Then, compare them. Borrowing from your 401(k) generally requires repayment within a set payback period (typically five years), and if you leave your job before it’s paid back, you might owe all the money in a short period of time. 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 may be significant costs involved. You will especially want to be prepared for possible withdrawal penalties.
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What are the long-term effects of using my 401(k) to pay off debt?
Using your 401(k) for debt may seem tempting, but it might not be worth the downsides. Depending on debt costs, penalties, taxes, and loss of retirement, cashing out your 401(k) to pay off debt could hinder your long-term financial goals.
What are some other ways to pay down my debt?
Because of the possible impact of cashing out your 401(k), you might want to consider other ways to both save and pay down debt. Here are some strategies:
1. Create a budget
If you don’t already have one, now is a good time to start exploring how to create a budget. When you put it on paper, it may 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. This could help you avoid the added costs of withdrawal penalties and taxes from cashing out your 401(k).
2. Choose a budget strategy for tackling debt
One key to a good budget starts with lowering your debt while still allowing for the occasional splurge. There are two ways you might consider helping make this happen: The debt snowball or debt avalanche method. Once you’ve decided on a method, you could begin to repay your debt.
3. Explore a debt consolidation loan to lower your monthly payments
Sometimes the sheer number of outstanding accounts is the most overwhelming thing about debt, especially if they have different repayment terms and the bills come due at various times during the month. For those looking to simplify higher-interest debt into one fixed monthly payment, a debt consolidation loan may be the right option.
With a personal loan for debt consolidation you could combine your various debts into one monthly payment with a fixed interest rate. Plus, a loan for debt consolidation may give you a light at the end of the tunnel: your one set regular monthly payment schedule lets you circle an end date on the calendar. That way, you will be able to see when the loan will be paid off. Personal loans come with a variety of repayment schedules, letting you choose the amount you’ll pay each month.
4. Temporarily suspend 401(k) contributions
Another alternative to using your 401(k) to pay off debt is to stop contributions temporarily and use that cash to pay down your debt.
Keep in mind that if your employer matches a percentage of your personal 401(k) contributions, stopping your contributions means missing out on those matching funds. Try to contribute at least as much as your company matches so you don’t lose out on “free money.” If you choose this method, remember to restart contributions when your financial situation allows.
How can I move towards a debt-free future?
Using your 401(k) may appear to offer some immediate advantages, but take the time to carefully review the possibilities. You might be pleasantly surprised to know that it is possible to keep saving while paying down debt—without touching your 401(k).
A debt-free future may be closer than you think. Find out how much you may be able to save on interest with a debt consolidation loan from Discover®.
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The information provided herein is for informational purposes only and is not intended to be construed as professional advice. Nothing contained in this article shall give rise to, or be construed to give rise to, any obligation or liability whatsoever on the part of Discover, a division of Capital One, N.A., or its affiliates.