Assess Your Current Financial Situation
Sit down and create a list of your savings, assets, and debts. How much debt do you have? Are you able to allocate different funds towards debts? If you have $2,500 in credit card debt and a steady source of income, you may be able to pay off debt by adjusting your existing habits. Cutting the cord with your TV, cable, or streaming services could be a great money saver.
However, if youre on the verge of foreclosure or bankruptcy, living with a strict budget may not be enough. When looking into more serious debt payoff options, your 401k may be the best route.
Not Without Paying A Penalty If You Are Younger Than 59
Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.
If you are over age 59½, you are free to use your 401 to pay for anything you like. If you are younger, you can still withdraw funds from your 401 to pay off college loans, but the IRS charges a 10% penalty tax on the amount of your withdrawal, in addition to any income tax that may be due.
However, you can borrow from your 401 instead of taking out a student loan, and there are a few ways you may be able to use retirement savings to pay for college expenses.
Why Nitzsche Used His 401 To Pay Off Credit Card Debt
Nitzsche speaks from experience. He is 40 now and a self-proclaimed “credit junkie” with a credit score over 800, but in 2008 when he was in his twenties and laid off from his job, he was burdened with having to pay a mortgage on a new home, just over $20,000 in student loans and over $10,000 in credit card debt.
He made some lifestyle changes, such as having three others live in his St. Louis, MO, home at the time to split mortgage and utility payments. But one of the biggest decisions he made was completely tapping into his retirement savings what he estimates was about $20,000 at the time to pay off his credit cards. Nitzsche tells Select that it was a decision he likely would not make again.
“That decision was largely done out of just panic and prioritizing,” Nitzsche says. “I knew that I wanted to do everything possible to stay in good shape to keep my home because I had just bought it a year before and obviously had a lot of pride in home ownership.”
But now that over ten years have passed, Nitzsche is still feeling the effects of his decision, and he’s not sure he would encourage someone in a similar scenario to do what he did.
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Most People Have Two Options:
Whether youre considering a loan or a withdrawal, a financial advisor can help you make an informed decision that considers the long-term impacts on your financial goals and retirement.
Here are some common questions and concerns about borrowing or withdrawing money from your 401 before retirement.
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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Consider A Hardship Extension
Even the IRS understands that sometimes, youre facing such a financial hardship that youre simply unable to pay your taxes at this timeyou need your tax money to survive.
In this case, you should likely apply for a hardship extension with the IRS.
Of course, youll have to prove to the IRS that financial hardship does currently exist, and this process can sometimes take longer than youd like.
As of this writing, it is free to apply for a hardship extension.
However, you will be charged 3% interest on top of the short-term federal interest rate when applying for a hardship extension.
Using A 401k Hardship Withdrawal To Pay Off Debt
One option for uncovering a large sum of money may be waiting for you in your retirement account. A 401k hardship withdrawal is not available for everyone. If you are certain that your employer allows for hardship withdrawals, this is an avenue you may wish to explore.
A 401k hardship withdrawal is allowed in circumstances where you have significant financial need and you have no other possible option to receive the money. There are other rules you must follow as well. The amount you withdraw cannot be more than the amount needed, and you wont be able to start re-building your 401k account for six months after the money has been withdrawn. This can be the best possible way to access money to pay down your debt and begin living debt free.
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What Is The Long
Ever heard the old proverb, Let the sleeping IRA lie? No? Just us? The purpose of retirement funds is to make sure youre taken care of once the income stops rolling in. But too manypeople treat their retirement fund as their emergency fund. And the more money you take out now, the less youll have for those beach-vacationing, golf-playing, grandkid-visiting days of retirement that you dream of.
When your IRA becomes an ATM, you lose out on all the money you would have earned with compound interest. Compound interest is your best friend, but only when you give it the opportunity to work. Thats what we call free money to those who wait. Its not money for today its money for tomorrow. Youre in it for the long haul, and investing takes a decent amount of patience and self-control.
Lets say you took $50,000 out of your IRA to pay off your student loan debt. You could end up paying about $5,000 in penalties and around another $15,000 in taxesleaving you with only $30,000. Thats not okay! But if you left that IRA alone, the original $50,000 invested at a 12% rate of return for 20 years would be worth over $544,000! And thats if you dont contribute anything on top of that. See? Having patience and leaving that money alone pays off big-time.
Use our investment calculator to see what your IRA will be worth when its time for you to retire.
Tax Penalty For Taking Money Out Of Your Roth 401k Early
Since you paid initial taxes on your Roth 401k contributions, you may take your contributions back out without paying a penalty. In other words, if you invested $25,000 and your investment has grown to $50,000, you may take up to $25,000 out of your Roth without paying an early withdrawal penalty.
In contrast, if you took $30,000 out of your account, you would pay a 10% penalty on the $5,000 because that was an investment gain and more than your $25,000 contribution. However, before you run out and take your contributions out, keep reading to see the devastating impact taking your money out of your investments early can have on your retirement savings.
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When It Doesnt Make Sense To Use A 401 Loan
While there are situations when it makes sense to use a 401 loan to help you pay down debt, its important to carefully consider your situation. Here are some times when borrowing from a 401 to pay off debt doesnt make sense.
- If youre nearing retirement and cant afford to take the money out of the market
- When you see it as a quick fix and dont have a plan to improve your long-term finances
- If youre unsure of your job security and think you might change jobs before you pay off the loan
Additionally, it might not make sense to use a 401 loan to pay off student loans. If you have a lower interest rate and you rely on federal protections like PSLF or income-driven repayment, you could lose out by taking money out of your 401.
Loans To Pay Off Debt
Loans from a 401 plan have their own set of rules, of course. To begin with, your plan must permit them. If loans are allowed, they are limited to 50% of your vested account balance or $50,000, whichever is less. So, for example, if you have $30,000 in your 401, the maximum you could borrow is $15,000.
In general, a 401 loan has to be paid back within five years . And if you leave your job, then you could have to repay your loan even sooner. Any amount you dont repay can be subject to taxes and penalties just as if you had withdrawn the money.
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Remember That You Can Do Both
Letâs not forget the third option: splitting the difference. The issue of debt payoff versus retirement doesnât have to be an either/or proposition.
âIf you are like most people, you need to balance debt paydown and retirement savings,â deMauriac says.Many people can tackle both debt and retirement goals at the same time. Focusing on retirement even while paying down debt is acknowledging that in addition to becoming debt-free, you want long-term financial security.
First of all, you should always pay the minimum on each debt balance to avoid losing assets or incurring large penalties. After that, you may wish to design your own plan that involves both debt payoff and retirement savings concurrently.
One of these approaches may fit:
- Pay off high-interest debt as quickly as possible, but invest a small amount in retirement.
- Pay only the minimums on debt while maxing out retirement contributions.
- Contribute up to your employerâs 401 match and put the rest toward debt.
In each of these situations, you would gradually shift the balance of how you prioritize your goals. As debts decrease, add more to retirement. Itâs impossible to provide a one-size-fits-all answer, given the wide variations in financial circumstances and emotional responses to debt.
Using Your 401 To Pay Off A Mortgage
Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.
There are some understandable questions you might encounter as you plan for retirement: Is it sensible to be squirreling away money in an employer-sponsored retirement plan such as a 401 while simultaneously making a hefty monthly mortgage payment? Could it be better, in the long run, to use existing retirement savings to pay down the mortgage? That way, you’d substantially reduce your monthly expenses before you leave behind work and its regular paychecks.
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Major Hardship Withdrawal To Access 401k
There are certain situations where you can access your 401k funds while still employed. If you qualify for an IRS-allowed major hardship you may access your money early but will still be subject to a 10% early withdrawal penalty.
According to the IRS, a major hardship withdrawal can be defined as:
- Certain medical expenses
- Costs related to buying a home
- Educational expenses
- Needing money to avoid eviction or foreclosure on a primary residence
Generally, the IRS relies on the employer to ensure the employee takes distributions related to the hardship.
What Are Some Alternatives To Taking Money Out Of Your 401
When it comes to paying down debt, your 401 isnt the first or only place you can look for relief. There are some solid alternatives.
For example, refinancing your debt might be an option. Refinancing your student loan or auto loan can mean getting a lower interest rate than youre currently paying. This is especially true if your credit score or income has improved since you first took out your loan. If you took out educational loans when you were still a student, for example, youre likely making more money now and might have built up a credit history that could make you eligible for a better deal.
If you have federal student loans and are still working toward that dream job , you could look into income-driven repayment plans that limit the amount that you pay each month to a certain percentage of your monthly discretionary income which could help keep your monthly payments more manageable.
Many of these plans will also forgive any remaining balance on your federal student loans after 10, 20, or 25 years of qualifying, on-time payments something that you wont be able to take advantage of if you pay off your loans with your 401.
If you still need help, you could look into whether you qualify to have your federal student loans put into forbearance or deferment. .
While extending your loan term means youll likely pay more in interest over the life of your loan, it might be a worthwhile move to ensure you can cover your debt payments.
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How Much Can I Borrow From My 401k
Current IRS rules allow you to borrow up to 50% of your vested account balance or $50,000, whatever amount is less. However, if your account balance is $10,000 or less, you can borrow up to the total balance or $10,000, whichever is less.
Whatever amount you borrow generally must be repaid in five years.
The Bottom Line On Borrowing Against A 401 To Pay Off Credit Cards
Taking out a 401 loan can be a flexible and affordable option for paying off credit card debt. Still, if youre going to go this route, its best to proceed with caution. At a minimum, youre going to want to take some time to reflect on your financial attitude and spending habits. Once you borrow against your retirement account to pay off debt, its a good idea to examine your budget and spending habits regularly. Doing so can help you avoid ending up with debts that feel overwhelming.
If you have more questions about ways that you can consolidate your debts, call us at 890-7337 or fill out our short contact form. Well be in touch with more information about how we can help you.
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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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Can I Use An Ira To Pay Off Student Loans
If you have a Roth IRA, that may be a better option for paying off your student loans than a 401. With these accounts, you wont pay a penalty as long as you only withdraw an amount equal to or lesser than your total contributions.
Keep in mind:
Roth IRA withdrawals also arent taxable. Since you fund them with post-tax dollars money youve already paid taxes on you can withdraw them tax-free at any time.
Despite these advantages, pulling from your Roth IRA means less money and less growth when it comes time for retirement. Additionally, not everyone is eligible for a Roth IRA. For example, if youre single and make $144,000 annually or more, you wouldnt be eligible to contribute to one. For married couples who file their tax returns jointly, the threshold is $214,000.
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When It Makes Sense To Use 401 To Pay Off Debt
Sometimes, it might make sense to use a 401 to pay off debt. For example, using a 401 loan to pay off debts with 15% to 20% interest could make sense, since you will be paying a lower interest on the 401 loan, mostly below 5%.
If you have upcoming debt payments and you have no way to pay them, taking money out of your 401 could help you avoid racking up more fees, penalties, and even dent your credit score.
In addition, if you are on the verge of defaulting on a loan, a 401 can help you avoid dire consequences such as court action, wage garnishment, or even losing the assets pledged as collateral. If loan payments and defaults appear on your credit card, it could affect your chances of getting a loan, getting a job, or even qualifying for a mortgage
The High Cost Of Hardship Withdrawals
So what’s the best way to have money for unexpected expenses? Build an emergency fund. You can tap into that without incurring early withdrawal penalties.
Generally, you should have enough cash to cover three to six months of living expenses in case of an emergency, like being laid off from work.
If saving that much money seems daunting, start small. Aim to build a fund of at least $500 and go from there. Be sure to build your savings back up when you take money out of the account. Don’t forget to take advantage of the power of compound interest.
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