Consider A Personal Loan
Sometimes, whats 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 its 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 afinite payment schedule and a light at the end of the tunnel: youll 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.
How To Use A Retirement Account To Pay Off Credit Card Debt
President of Quest Education, teaching business owners about funding, paying off debt, and investing in alternative assets.
Many Americans have both credit card debt and a retirement account, such as a 401 plan or individual retirement account . This means they are likely losing money faster than they are making it.
According to WalletHubs Credit Card Landscape Report, interest rates average 17.98% for new credit card offers and 14.58% for existing accounts. In regard to retirement accounts, one commonly hears that investors can expect an average 6%-7% annual return in the stock market over the long term. Losing 17.98% per year on a portion of your money and then making 7% per year on another bucket of money means you could be going backward financially. However, there is a lesser-known option to fix this problem using your retirement account.
Some people consider taking funds out of their retirement account only to discover that withdrawing money from the IRA/401 plan would cost 20%-35% in penalties and taxes to the IRS. That would mean if a person takes out $20,000 from their retirement account to pay off credit card debt, there could be up to $7,000 in penalties and taxes paid.
Why Focusing On Retirement Generally Works
Retirement plans and emergency savings are both critical pieces of your overall financial puzzle, and retirement should be a major priority, as a rule of thumb. Dollars invested early on can have an exponential impact on retirement earnings, Lynch said, due to compound returns and market gains over time.
Calculate how much your current and any additional savings could be worth by retirement age with the U.S. Department of Labors Lifetime Income Calculator.
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In A Nutshell: Freedom Provides Debt Consolidation Services To Help Customers Get Rid Of Debt
If you find yourself struggling to pay back your debts and are searching for a way out, a debt consolidation service can help relieve the burden and formulate a plan to get you rid of debt.
For over a decade, Freedom Debt has built a reputation as a reliable debt solution helping customers pay off their debt quickly. Their service specializes in unsecured debt and is ideal for those with credit card debt or individuals facing bankruptcy. While their service is not for everyone, a debt consolidation service can be helpful for those struggling with upwards of $20,000 in debt who are committed to sticking with a plan and living within their means. The service can have a negative impact on your credit score and should only be used as a last resort.
Applying with Freedom Debt is easy and requires no commitment. To get started, prospective customers simply input basic details such as debt amount and what state they are located in, and then they are connected to a Freedom Debt consultant. Like all reputable debt consolidation services, the entire application process is completely free and users should be extremely wary of services that require payment upfront. Once you sign up, there is a fee for completing the process but the ultimate goal is to use the service to help you become debt-free.
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What Are The Penalties Assessed On Early Distributions
Because retirement funds are meant to stay in your account long-term, youll be penalized if you withdraw money before age 59½. Youll likely have to pay this amount on a traditional account, though you may not have to pay it on a Roth account.
There are also some exceptions to the early withdrawal penalty on traditional IRAs and on 401 accounts.
You can withdraw any contributions from your Roth account without paying taxes or penalties. However, if you want to withdraw earnings, penalties and taxes may be assessed. This depends on how long youve held the account and the purpose of the distribution. For more details, check out these Roth IRA withdrawal rules and understand the same will apply for Roth 401s.
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What Is A 401k Hardship Withdrawal
A 401k hardship withdrawal is legally allowed if you meet the Internal Revenue Service criteria for having a financial hardship and if your employer allows for them.
Most companies providing 401k plans allow hardship withdrawals check with your human resources department or plan administrator if youre not sure.
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Is Cashing Out My 401k Ever A Good Idea
As a coach, I have found that there are two exceptions to this otherwise rigid rule: avoiding bankruptcy or foreclosure.
Both bankruptcy and foreclosure are extremely heavy burdens to bear. A Chapter 7 bankruptcy will clear ones debts and wipe the slate clean. But the bankruptcy trustee takes away certain assets for liquidation. One may reaffirm certain debts, such as cars, but the debtor still owes the creditors for those debts not liquidated in the Chapter 7.
A Chapter 13 bankruptcy is a three-to-five-year payment plan where the debtor gives a large portion of financial control to the Chapter 13 trustee. It is difficult to do anything during this time, even a debt snowball, so I strongly recommend avoiding bankruptcy in nearly all circumstances.
Foreclosure is also a devastating experience. Imagine losing the home youve lived in for years, made renovations on, and in which you dreamed about raising your family. The foreclosure sweeps that away, wrecks your credit, and uproots stability in your familys life. It can take years to get back to the point of even being creditworthy to get a mortgage again.
Normally, I do not suggest cashing out a 401k to pay off debts. But if your current track is either a bankruptcy, or a foreclosure, or even both, then it may be something to seriously consider only to avoid either of those things from happening.
The cost of the early cash-out is high, but not necessarily as high as bankruptcy or foreclosure.
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Other Methods To Quickly Pay Off Debt
- Take the time to contact your credit card company to negotiate a better interest rate. If the first person you talk to refuses to negotiate, ask for their supervisor and explain your situation. It never hurts to ask!
- Other may offer you a lower rate to transfer your balance. Be extra careful of 0% interest rate cards. They use 0% to entice you in, only to charge 20% or more after the first 0% interest year runs out. Read the fine print! Refer to The Best Way To Pay Off $10,000 In Credit Card Debt.
- If you have multiple student loans, it may make sense to consolidate them if your credit score has improved.
Should You Withdraw Your Retirement Funds Early
Short answer no!
Longer, clearer answer even if your credit card interest rates are higher than your tax rate, its almost never a good idea to withdraw your retirement savings early. Heres a rundown of the types of retirement accounts you may have and the costs youll incur if you withdraw from them before retirement.
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Dont Be Surprised By 401 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 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.
Alternatives To A 401 Loan
Although 401 borrowing has some advantages, including not having to jump through hoops for a commercial loan or undergoing a check of your credit score, there are downsides that discourage many would-be borrowers from using their retirement money in the present. Here are a few:
- Tax penalty for not repaying the loan on schedule.
- Loss of growth. 401 money could be invested in a mutual fund and grow tax free for many years until you retire. Money borrowed doesnt grow, and the loss of compounding growth can make a big difference in your older years.
- You could get in the habit of using your 401 as a piggy bank, defeating its value as a savings tool.
- While you are paying back what you borrowed, you might not have the money to add to your account, further reducing its future value.
- 401 accounts are protected in bankruptcy. If you borrow money to help pay off a big debt and then discover that you still cant avoid bankruptcy, you will lose whatever you withdrew. Not touching the 401 safeguards the money for your retirement.
After considering the drawbacks, many would-be 401 borrowers decide to look elsewhere for the money they need. Here are a few options:
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Does Withdrawing From Your 401 Affect Your Credit Score
Borrowing from your 401 can put your retirement at risk, but it wont hurt your credit score.
Unlike applying for a credit card, no lender will do a credit check if you borrow from your retirement fund. And even if you miss payments or default on your loan, this information wont be submitted to credit-reporting agencies.
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Is Borrowing From A 401 To Pay Off Debt Possible
First and foremost, yes, it is possible to borrow from a 401 to pay off debt. The question is whether or not it is advisable to do so. Typically, your retirement savings should stay in your account until you are old enough to start taking regular distributions. Spending the money before youve reached retirement age may leave you short in your golden years.
In light of that, if you are considering borrowing money from a retirement account to pay off debt, its a good idea to talk to an advisor about your financial goals first. They may recommend temporarily pausing retirement contributions and using the extra income to pay down your debts rather than taking money out of your account. However, the decision is yours to make.
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Are 401 Withdrawals Subject To Taxes And Penalties
Even if you can qualify for a hardship distribution, its a good idea to plan to pay taxes on the distribution . And, unless you meet specific criteria to qualify for a waiver , youll also pay a 10% early withdrawal penalty if youre younger than 59½.
So, lets say youre 33 years old, and you have enough in your 401 to withdraw the $20,000 you need. Right off the top, unless you qualify for a waiver, you can expect to pay a $2,000 early withdrawal penalty. Then, when you file your income tax return, that 401 distribution will most likely be counted as ordinary income, so it will cost you even more. And if that added income bumps you into another tax bracket, you could end up paying even more.
But taxes and penalties arent the only costs to consider when youre deciding whether to go the distribution route.
Since compound interest creates the potential for your initial investment to grow significantly over time, every dollar you take out now could mean several dollars less in retirement. Essentially, withdrawing from your 401 now is like borrowing money from your future self, because youre losing long-term growth.
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Why Are People Cashing Out 401k
Cashing out a 401 gives you immediate access to funds. If you lose your job and use the money to cover living expenses until you start a new job, an early 401 withdrawal might help you avoid going into debt. … Leaving money in the account, rather than taking it out, could help you reach those financial goals.
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Pay Off Debt Or Save For Retirement
Theres certainly nothing wrong with using extra cash to pay down debt every month. Maybe you are the kind of person who thinks if the money is sitting there in a retirement account, youll use it and lose it, so youd rather pay off debt. Or perhaps you just sleep better at night without feeling like you owe someone money. Its hard to put a price tag on a good nights sleep.
It really comes down to personal preference, Henry says. Mathematically speaking, the best route would be to maximize your retirement savings as much as possible and take advantage of the low interest rate environment were in on your debts . However, I dont always do things based exclusively on the numbers. Theres a psychological and relational aspect to the world of finances Ive yet to ever meet anyone who ever regretted paying off all their debt.
Borrowing Against Your 401 Is It Ever A Good Idea
Many full-time and part time employees have the benefit of a company-matched retirement plan, referred to as a 401 for the part of the tax code authorizing it. These tax-deferred packages are the principal retirement vehicle for just over half of people in the United States. Americans put away about 6% of their pay in 401 plans to receive employee matching and tax breaks.
One feature many people dont realize about 401 funds is that the account holder can borrow against the balance of the account. About 87% of funds offer this feature. The account holder can borrow up to 50% of the balance or $50,000, whichever is lower, but the whole amount must be repaid within 5 years. Theres no approval process and theres no interest. Its basically a loan you give yourself, and is a popular enough option that 17% of millennial workers, 13% of Gen Xers and 10% of baby boomers have made loans against their 401 accounts.
Despite these benefits, borrowing against a 401 is a risky proposition. There are harsh penalties for failure to repay and taking money away from retirement savings is always risky. Borrowing from a 401 account should not be a decision that is made lightly.
As with most financial moves, there are benefits and disadvantages to borrowing from a 401. It can be difficult to sort through them, particularly if your need for money is acute and immediate. Before you borrow from a 401, though, ask yourself these four questions:
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Why Do People Use Their 401 To Pay Down Debt
Although there are significant costs involved in taking money out of a 401 to pay debt, many people still do it. It can seem like a good option if you have high-interest debt like credit card debt and you have to face those bills every month. If you have lower interest debt like student loans, personal loans, auto loans, or a home equity line of credit , then the early withdrawal penalty and other consequences may be a deterrent.
But if youre paying high interest on your current debt, or if you have debt payments due and no way to cover them, using your 401 might seem better than the risks of missing payments on those bills. Late payments can rack up fees, interest, and can ding your credit score. And if you default on a debt, that can have even more dire consequences, potentially including court actions and wage garnishment depending on the type of debt and the creditor or lender. You cant exactly wait it out and count on winning the lottery or inheriting money from some long-lost relative.
If your credit score ends up damaged due to late payments, that, too, could have a huge impact on your finances. Having a low credit score can make it more difficult to get loans in the future. You might have to pay a higher interest rate or there might be limits on how much you can borrow.
What Reasons Can You Withdraw From 401 Without Penalty
So, are there cases in which you can access cash through your 401 without incurring any penalty fees?
You generally need to be experiencing a serious financial hardship in order to qualify to withdraw early from your 401 without penalty. The guidelines are broad to allow for different contingencies, but generally you need to be dealing with major medical expenses or be at risk of losing your house, according to Seuthe.
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Are You Eligible To Withdraw Money From Your 401 To Pay Debt
First, youll have to determine whether you are able to use your 401 savings to pay debt. Your plan administrator and the IRS guidelines are great resources but generally, 401 distributions are allowed if:
- You reach age 59.5
- You die, become disabled or are otherwise withdrawn from the workforce
- Your employer terminates your plan and doesnt replace it with another
- The distribution is related to a financial hardship
That last one is important because not all employers allow hardship distributions from a 401. Even if your plan does allow hardship distributions, you must demonstrate that the funds will address an immediate and heavy financial need. That includes things like:
- Paying medical expenses for yourself, your spouse or your dependents
- Purchasing a principal residence
- Paying tuition, educational fees or room and board for yourself, spouse or dependents
- Avoiding eviction or foreclosure
- Funeral expenses
Keep in mind that every employer is different. Even if your employer allows a hardship distribution, they may not recognize each of these scenarios. In most cases, you wont be able to contribute to your plan within six months of taking a hardship withdrawal.