Should You Use A 401 To Pay Off Debt
In some cases, it could be beneficial to cash out a portion of your 401 to pay off a loan with an 18% to 20% interest rate, says Paul Palazzo, CFP, COA, managing director of financial planning at Altfest Personal Wealth Management.
For debts with lower interest rates, such as a home mortgage or student loan, taking a 401 withdrawal, and paying both income taxes and a possible 10% penalty on it, would make little financial sense.
Thats especially true when you consider that youd be sacrificing $45,000 in retirement savings, plus their future earnings.
Fortunately, there are some alternatives.
Should You Pay Off Your Mortgage Early Before You Retire
Some people enjoy the peace of mind that comes with a debt-free retirement. But warm and fuzzy feelings should be weighed against solid financial facts.
When it comes to paying off your mortgage, for example, first take a look at the interest rate. If the rate on your mortgage is low, you might be better off holding onto your cashor even investing it, assuming youre reasonably confident you can get a higher rate of return than youre paying on the loan, says Rob Williams, vice president of financial planning at the Schwab Center for Financial Research. “But, at the same time, reducing debt, and ideally eliminating it, all else equal, should be on your list of goals before retirement.”
With interest rates are at a record low, including sub-3% mortgage rates, it may be tempting to refinance a mortgage or not pay it off. But its worth keeping in mind, that it’s hard to get a 3% guaranteed investment return from any investment today. Being “reasonable confident” you get a higher rate of return involves risk. Its important to evaluate your risk tolerance before making a decision.
Here are the pros and cons to consider before retiring a home loan.
When Using Your 401 To Pay Off Debt Makes Sense
It might make sense to defy conventional wisdom and dip into your 401 for certain situations.
Employer-sponsored 401 plans form a retirement-planning cornerstone for millions of Americans.
These accounts allow workers to save money for the future through payroll deductions at work and, in many cases, provide an employer match that can significantly bolster retirement nest eggs.
Those participating in 401 plans may contribute up to $19,500 this year, according to the IRS, plus another $6,500 in catch-up savings for workers age 50 and older. Besides saving for the future, employees can lower their current income tax bills by contributing to these tax-deferred accounts.
Financial experts tend to recommend leaving your 401 alone and letting the money grow so youll have it later in life. Current financial needs, however, may tempt you to tap into your retirement account now.
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Cons Of Using 401 To Pay Off Debt
When the stock market is consistently rising its known as a bull market. That means the funds in your 401 plan are increasing in value. Taking them out while that is happening could cost you those potential gains. This is the most common argument against 401 loans, but it only affects you when the market is bullish. Other legitimate cons include the following:
- Risk of Job Loss: As we all learned in 2020, no job is guaranteed to be secure. If you lose your job while you still owe money on a 401 loan, the IRS requires you to pay off the remaining balance within sixty days. Failing to do that will reclassify the loan as an early withdrawal and youll be subject to a 10% fee and income taxes.
- The S& P 500 is Up 20% This Year: The timing for a 401 loan should be carefully considered. The S& P 500 is up 20% this year, so taking funds from your retirement account is probably not the best option. A personal loan, despite the higher interest rate, would be more cost-effective.
Consider Other Funding Sources
Before you reach into your 401, consider alternatives, including negotiating with creditors to lower your interest rates, reduce your balance or put you on a payment plan.
Debt.org cites other possibilities, including nonprofit credit counseling, which can provide a debt-consolidation plan, or finding a reasonable home equity loan. You also might use a family loan or transfer a high-interest balance to a zero-interest credit card.
Consider talking to a professional to help you make the best move.
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Should You Use A 401k Loan To Pay Off Debt
About Kevin
Kevin is a former fintech coach and financial services professional. When not on the golf course, he can be found traveling with his wife or spending time with their eight wonderful grandchildren and two cats.
At a Glance
Carrying too much debt is a problem that can affect you in several other areas. At first glance, using funds from your 401 plan to pay off that debt may seem like a good idea, particularly if you have high-interest credit cards. Its your money. Why not use it? Thats the question well attempt to answer for you today. Here are the pros and cons of using a 401 loan to pay off debt:
Should You Take Money From Your 401 To Pay Debt
If youve been using a workplace retirement plan like a 401 and you should be, to take advantage of compound interest and any employer match available you may at some point find yourself looking at the stores of money and wondering if you should use some of it to deal with current financial issues rather than saving all of it for your retirement. Everyone deals with financial troubles at some point, and it is understandable to look at that pile of untouched money and think you should just dig in now. While there are certainly some situations where this may be a good idea, if its possible to avoid raiding your 401, it is better to let it sit, for a variety of reasons explained below. If youre struggling with financial issues and want help, consider finding a financial advisor.
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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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You Could Miss Out On Future Earnings
In short, cashing out your 401k simply to pay down debt could be robbing your future self. Thats because in addition to the cash youll lose in taxes and penalties, you could also lose out on the wonders of compound interest and/or investing over time.
Those are things that could put a huge amount of money in your pocket over time.
Rolling over your money to an IRA is usually a much better option than cashing out your 401k for debt reduction. Its not really even much trouble, especially if you do a direct rollover. Doing a direct rollover means that you never have to handle the money yourself.
If you have an existing IRA, its often just a matter of telling your employer that you want to do a direct rollover to that IRA. If you dont already have an IRA set up, it doesnt take much paperwork to get it done. Then you can go ahead with a direct rollover to that.
If you take money out due to a hardship, you also usually wont be allowed to contribute to your 401k plan for a period of six months after you do so. Again, that reduces the time for possible earnings.
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.
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Should I Use My 401k To Pay Off Some Debt
An individual who uses their 401k to pay off debt can incur more debt. Typically, the idea of using a portion of the 401k for debt relief is alluring. For instance, someone can borrow money from their 401k retirement account and repay within a specific amount of time such as five years of the date of the withdrawal. What sounds better is that the person is paying the interest on the amount back to themselves instead of a loan company. However, borrowing money from a 401k means paying taxes on the amount and having a penalty assessed if the individual is under the age of 59 and ½. The penalty exists because the purpose for retirement plans is to use them for retirement and not for debt relief, according to Bankrate.
Tips For Balancing Debt And Retirement Planning
- Saving for retirement while paying off debt can be challenging. A financial advisor can help you develop strategies for both. An advisor can also discuss the potential tax implications if you decide to tap your employer-sponsored plan. SmartAssets free tool matches you with financial advisors in your area in 5 minutes. If youre ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Explore alternatives to a 401 withdrawal before making a final decision. There are numerous options that may be a better fit, such as using a 0% APR balance transfer credit card to consolidate debt, getting a personal line of credit or borrowing against your home equity. Each of these can be used to pay down debt, while leaving your retirement savings intact.
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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
How Are My Early Distributions Taxed
When you withdraw money early from your 401 or IRA, youll be required to pay taxes. If you have a Roth account, the taxes have already been paid, so skip this step. If its a traditional account, youll be required to pay your normal income tax rate, and your state also will likely take its cut too.
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The Cons Of Borrowing From Your 401k
Up until now, using a 401k loan to pay off debt you owe to the IRS must seem like a pretty great deal.
You dont really pay interest, you can avoid a credit check, and youll be able to access the money incredibly quickly.
As with any type of loan, however, there are a few reasons why this might not be the right move for you.
First of all, whenever you borrow from your retirement savings, youre putting your financial future at risk. This is especially true given that when you pay back what youve borrowed, you must repay it with after-tax funds.
If youre in a 20% tax bracket, for example, every dollar you put towards repaying a 401k loan is actually only 80 cents. Its easy to see how over time, this could chip away at your retirement savings in a pretty significant way.
Additionally, depending on employer regulations, you may not be allowed to continue to make contributions to your 401k until youve completely repaid your loan. This is, perhaps, the biggest reason to look into other avenues of paying back your taxes.
Remember too that youre also missing out on the opportunity for the money you took from your 401k account to earn any kind of investment returns.
Plus, you need to consider the unfortunate reality of an even greater potential financial hardship. What if you become ill and are faced with high medical bills? What if your home is hit by a natural disaster?
Youll be hit with another 10% early withdrawal fee.
Is There A 401 Withdrawal Penalty
If youre wondering how to cash out your 401, 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 requires repayment, within a set payback period . Withdrawing, however, means you withdraw a certain amount of money or cash out your 401 with no intention of paying it back.
While using 401 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:
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What Does Tax Advantaged Mean
Tax-advantaged means the fund is subjected to different tax rules that generally are geared in favor of the investor. Taking advantage of these types of accounts means you can usually save and invest more money by either deferring taxes or being exempt from taxes .
There are two main tax-advantaged 401k plans:
- A Roth 401k
- A Traditional 401k
How A Tax-Deferred 401k Works
A traditional 401k defers taxes until you draw money out of the account. In simple terms, your employer will take money from your paycheck and invest it in your traditional 401k before any taxes are paid to the government.
For example, if you make $5,000 a month and invest $1,000 a month in your 401k, the $1,000 will transfer from your employer to your 401k thereby lowering your paycheck to $4,000. You will then be taxed at your regular rate on the $4,000 you receive.
The $1,000 you invest will grow over time and will not be taxed when it grows. When you decide to take money out of your 401k, after the age of 59 1/2 you will pay taxes on the money you take out of your account. For instance, if you are still receiving $4,000 a month and take out $1,000 from your 401k, you will pay taxes on the $5,000 in income at your regular rate.
How A Tax Exempt 401k Works
A tax-exempt 401k is referred to as a Roth 401k. While not truly exempt from all taxes, a Roth pays taxes upfront, but nothing on the gains or withdrawals. When you invest money in a Roth, you invest after-tax money in this account.
The Dangers Of Taking Out A Loan On Your 401k
I want to stress to you that taking out a personal loan or getting in the habit of borrowing money from your 401k is not a great idea. If you withdraw funds or take a loan from your 401k to pay your debts, there is no guarantee you fixed the problem that got you in debt in the first place. Remember, you are punishing your future self and your ability to retire comfortably by using it today.
Focus on getting out of debt the old fashioned way, by spending less and saving more! Build better spending habits and show your debt whos boss!
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