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Can I Use 401k To Pay Off Credit Card Debt

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What About 401 Loans

Should I Use a 401(k) Loan to Pay Off My Credit Card Debt?

Some 401 plans give you the ability to borrow funds from your 401 account. As long as you pay the funds back as required, you could avoid the taxes and the interest penalty from the IRS.

However, this isnt a great idea for paying off credit card debt either.

If you dont repay your loan, you will pay at least 25% of your withdrawal in taxes and penalties, though it could be more depending on your annual income and tax bracket.

If you dont pay the funds back, you are also out those dollars when you reach retirement.

Many financial experts suggest saving at least 10% to 15% of your income each year to maintain the same lifestyle in retirement. If you withdraw early, youre potentially setting your future self back for retirement.

Should I Contribute To My 401k Or Pay Off My Credit Card Debt

Its been nearly seven years since the financial crisis swept through the nation, yet two-thirds of Americans said they still feel haunted by its effects in the way they work, live, save and spend, according to a study from Allianz Life Insurance Co. Many of the 2,000 baby boomers and Gen X-ers studied also said they had lower confidence in their ability to achieve financial security.

For workers who hold credit card debt, which is more likely to lead to a secure future: diverting what wouldve been their retirement plan contribution and paying off that debt instead or making their 401k plan a priority? Here are some pros and cons associated with each of these money moves.

Should You Use A 401 Loan To Pay Off Your Credit Cards

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Many 401 plans allow users to borrow against their retirement savings. Its a relatively low-interest loan option that some people use to consolidate credit card debt meaning, taking a more favorable loan to pay off several high-interest credit card balances. But NerdWallet cautions against taking a 401 loan except as a last resort.

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Roth Ira Early Withdrawal Penalty

Since Roth IRAs are funded with post-tax income, they have slightly different early withdrawal rules than traditional IRAs and 401s.

Roth IRA funds are divided into two types:

  • Contributions: the money you contribute to your account
  • Earnings: the money your contributions earn through interest and market growth

Contributions can be withdrawn at any time without paying additional taxes or penalties.

When you withdraw earnings, you have to pay tax on your withdrawal along with a 10% penalty unless the earnings are considered a qualified distribution, in which case you only have to pay taxes.

Since paying off debt is not a qualified distribution, assume youll have to pay both tax and the penalty.

Heres an example of how this might work.

Lets say youve contributed $15,000 to your Roth IRA, and the total value of your Roth IRA is $25,000, meaning you have $15,000 in contributions and $10,000 in earnings.

You could withdraw $15,000 from your Roth IRA without paying taxes or penalties.

If you withdraw $20,000, youll have to pay tax and a $500 penalty on the $5,000 in earnings you withdrew.

What does that mean? At the 22% tax bracket, withdrawing $5,000 in earnings will cost you $1,100. Add the $500 penalty, and thats $1,600 of your withdrawal gone forever.

Exceptions To The Withdrawal Penalty

Can I Use 401k To Pay Off Credit Card Debt

A few situations allow for exceptions to the withdrawal penalty, the most common being the hardship withdrawal. The early withdrawal penalty from a 401 can be waived if you prove and receive a need for hardship distribution. According to the IRS, you may qualify for a hardship withdrawal if:

  • You have an immediate and heavy financial need
  • You dont withdraw more than is necessary to satisfy your financial need

Some examples of instances when someone might need a hardship withdrawal include paying rent to avoid eviction, covering your mortgage to prevent foreclosure, paying for medical bills, repairing your house after a natural disaster and paying for the funeral costs of a loved one. During the COVID-19 pandemic, the CARES Act made it possible for qualifying individuals impacted by the pandemic to withdraw from their 401 without incurring an early withdrawal penalty.

Read Also: How To Retrieve 401k Money

Should You Take A 401 Loan

Taking a loan from your 401 is a better option than taking a hardship distribution however, it isnt necessarily a wise decision either. Not only does taking a loan leave you with less money invested for retirement, it also puts you in financial danger if you get laid off before the loan is fully repaid.

If you lose your job while youre repaying a 401 loan, the entire balance is due within 60 to 90 days. If you cant come up with the full amount, the outstanding balance is considered an early withdrawal, which is subject to income tax plus an additional 10% penalty, if youre younger than age 59½.

Though you pay interest to yourself on a 401 loan, you still miss out on potential investment gains and tax benefits on the balance you withdraw. Even if the interest rate you pay is higher than the accounts investment growth rate, you can still lose money in the long run. Before taking a loan, always research the financial consequences by entering your information into a 401 loan calculator.

Here are 4 reasons why taking a hardship distribution or a loan from your 401 should be avoided:

You may be subject to a 6-month waiting period when you cant make any new contributions to your planand you lose potential matching funds.

You lose out on years of potential account growth.

You must pay a 10% penalty, in addition to income tax, on early withdrawals.

You lose legal protection because 401 funds are shielded from creditors if you declare bankruptcy.

Using A Pension Loan To Pay Off Credit Cards

If you dont want to completely withdraw your pension, you may opt to use a pension loan, also known as a pension advance, pension sale, or pension buyout. Unregulated in the U.S., this support comes in the form of a loan paid in regular installments for a short or indefinite period of time, or as a lump sum.

Because they are unregulated, its not typically recommended to use a pension loan. Interest rates can be very high, you may be charged fees, and you could also find yourself in a higher tax bracket if the payment comes in a lump sum.

If your state does offer pension loans, there are usually specific criteria you must meet such as being an active member of the retirement system, having worked a certain amount of time, and having an application approved.

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The Lifestyle Challenges Of Borrowing From Your 401k To Pay Off Debt

According to The Debt Payoff Playbook, retirement contributions should be paused until you tackle your debts. There are several reasons for this sequence. By forcing yourself to change your lifestyle and spending habits, you will be able to tackle your debts quickly.

This is because pain is a motivator.

When you have debt, you acutely feel the pain associated with a debt burden. This keeps you motivated to pay the debt off as fast as you can, to free yourself from this position. After you pay off your debt, it is less likely that you will fall back into your old spending patterns. If you do happen to fall back into debt, you will have a proven strategy to quickly change your course to get back on track.

By pulling from your 401k account to pay off debt, we are assuming that you will contribute back to your 401k loan aggressively. Unfortunately, there is little reward or pain associated with retirement savings. It is delayed gratification that can be easily overlooked.

If you paid your debt off with your retirement, it is easy to justify slowing down retirement to pay for a newer vehicle with a higher payment. It is much easier to justify lowering retirement contributions to purchase consumer goods.

I hope you understand that the debt payoff process is as much psychological as it is mathematical. Its about changing your lifestyle and spending habits that you have held for decades.

Don’t Miss Out On Compound Interest

Retirees | Should You Use Your 401k to Pay Off Credit Card Debt??

Another compelling reason not to withdraw from your 401 to pay off your credit card balance, if you can avoid it?

Compound interest.

What this means, really, is you can earn interest on top of your interest in retirement accounts. If you withdraw that money early, you limit the speed at which your retirement savings can grow too.

Compound interest is one reason why many investment gurus recommend you start saving for retirement as early as you can.

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Withdrawing From 401 To Pay Off Debt

Withdrawing from your 401 retirement fund to pay off debt is almost never a good idea, Dunn said. Most economists would not advise the average consumer to cash in a 401k to pay off debt unless there were really unusual circumstances, she said.

Withdrawing money from your 401 comes with hefty penalties and tax payments. Usually, doing it costs you more money than its worth and damages your long-term financial stability.

Other Disadvantages To Withdrawing Early

Although withdrawing money from your retirement accounts might sound like the best solution to your debt problem, you have to consider all of the potential disadvantages:

Taxes and penalties

Youre paying what could be several thousand dollars in taxes and penalties just to pay off your debt. Thats like throwing good money after bad.

Withdrawals considered as income

Any money you pull from your retirement accounts is taxed as income and if that income pushes you into a higher tax bracket, youll pay even more taxes on the amount you just withdrew.

Lose the potential growth of retirement savings

Well look at exactly how much money you might lose in the next section.

Potentially, a bad financial habit

Withdrawing from your retirement fund now might make it easier for you to do it again in the future and if you withdraw too much, you wont have enough left in your accounts to fund your retirement.

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Exceptions For 401 Only

  • You leave your job the year you turn 55 or later .
  • The 401 is divided in a divorce under whats known as a Qualified Domestic Relations Order.
  • You overcontributed to your 401.

Theres also an exception to the early withdrawal penalty for a 401 if you receive a hardship distribution. This is money taken out of your 401 to meet an immediate and heavy financial need, according to the IRS, and could include things like repairing damage to your home after a natural disaster, covering funeral expenses for a loved one, or paying rent to avoid eviction. And youre only allowed to take out the exact amount needed for these expenses.

But even as it becomes easier to access your 401, remember that youre the one who has to live off that money when you retire. So be careful about what you call an emergency and save your 401 for later.

How To Pay Off Credit Card Debt

Can I Use 401k To Pay Off Credit Card Debt

9 Minute Read | October 04, 2021

If youve got credit card debt, it can feel like the life is being drained from your income every month. Purchases from months ago are haunting you and holding you back from doing what you want with your money today.

We get it. Weve felt the weight debt can put on you. And. It. Sucks.

The good news is, it doesnt have to stay like this. Use the tips and info here to learn how to pay off credit card debt. Put this months income back into this month. And then you can start putting more of it toward the future you want.

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The Interest Rate On Your Debt Matters

Unfortunately, we need to remember the 10% penalty that was added on. So to pay off that $40,000 debt, we would need to take $44,444.55 out of our retirement to account for the penalty.

If you take $44,444.55 10% Tax Penalty = $40,000.1

Had you left that money in there, in 5 years it could have grown to $65,303.63.

So, if it takes you 5 years to pay off this credit debt, you will have paid $18,363.00 in interest to the credit card company. But you missed out on $20,859.08 in gains you could have made from your investments if you left it alone.

Using Retirement To Pay Off Debt

If you choose, you can pull from your retirement to pay off debt. However, its not always recommended.

Most experts suggest leaving retirement funds in the retirement account so that funds are there when you need them and are no longer making your working wages.

There are also situations where you could incur fees or other penalties by withdrawing from your account. For example, youll be penalized if you withdraw 401 funds before age 59 ½. If you withdraw earnings from a Roth or traditional IRA, you may also have to pay penalties and taxes.

While in some cases you can pull from retirement to pay off debt, there are also instances where you could use a loan for debt repayment. If youre considering using a loan from your retirement funds to pay off debt, your options are a 401 loan or pension loan.

Also Check: How Can I Get A 401k Plan Without An Employer

Can I Take A Hardship Withdrawal For Credit Card Debt

hardship withdrawals401kwithdrawaltakehardship withdrawal

. In this manner, is credit card debt considered hardship withdrawal?

The initial problem may be a sudden large expense, a loss of income, or snowballing . But whatever the cause may be, digging yourself out of such a deep financial hole can be next to impossible. And that’s when a 401 hardship withdrawal can provide you with a lifeline.

Also Know, should I withdraw from 401k to pay off debt? ANSWER: You should not take the money from your 401-K to eliminate your debt because $14,000 will go to penalties and taxes that’s 40% of your savings. It’s like taking out a loan with 40% interest to pay off your debt. That’s a bad plan.

Also asked, can you take a 401k hardship withdrawal for credit card debt?

Simply put if you withdrawal your funds out of your 401 to pay off your not be recognized as hardship distribution according to IRS guideline.

How do you get approved for hardship withdrawal?

But, there are only four IRS-approved reasons for making a hardship withdrawal: college tuition for yourself or a dependent, provided it’s due within the next 12 months a down payment on a primary residence unreimbursed medical expenses for you or your dependents or to prevent foreclosure or eviction from your home.

Build Up A Cash Buffer

Dip Into My 401(k) to Pay Off My $25,000 Credit Card Debt?

Bonus points

Once you’re meeting your minimum obligations, it’s time to build some reserves. We suggest you start by saving up an initial cash buffer of $1,000 or one month’s rent, whichever is greater, to give you some breathing room in your day-to-day .

That way, even if occasional bumps come up, you won’t run the risk of missing bills because your checking account balance is too low.

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Can You Use A Pension To Pay Off Debt

About Caitlyn

Caitlyn is a freelance writer from the Cincinnati area with clients ranging from digital marketing agencies, insurance/finance companies, and healthcare organizations to travel and technology blogs. She loves reading, traveling, and campingand hanging with her dogs Coco and Hamilton.

At a Glance

During an employees years of work, their employer may make regular contributions to a pool of funds set aside for the employees future. The funds are invested on the employees behalf, and the earnings help make the pool grow larger. These funds, called a pension, can then be withdrawn to support the persons retirement.

As long as the person continues to meet eligibility criteria, they will receive a monthly payment from their pension, typically calculated with a formula taking into account their years of service, as well as their earnings.

Once you meet the eligibility requirements, the pension payments are yours to use for whatever you deem fit. However, if youre considering withdrawing those retirement funds early to pay off debt, there are pros and cons to weigh before making a decision.

In this article, youll find information about:

Should I Cash Out My 401k To Pay Off Debt

Paying off debt may feel like a never-ending process. With so many potential solutions, you may not know where to start. One of your options may be withdrawing money from your retirement fund. This may make you wonder, should I cash out my 401k to pay off debt? Cashing out your 401k early may cost you in penalties, taxes, and your financial future so its usually wise to avoid doing this if possible. When in doubt, consult your financial advisor to help determine whats best for you.

Before cashing out your 401k, we suggest weighing the pros and cons, plus the financial habits you could change to reduce debt. The right move may be adjusting your budget to ensure each dollar is being put to good use. Keep reading to determine if and when it makes sense to cash out your 401k.

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