Monday, March 18, 2024

Should I Cash Out My 401k To Pay Off Debt

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Rethinking The Question: Should I Pay Off Debt Or Contribute More To A 401

Should I Cash Out My 401k to Pay Off Debt?

Instead of asking whether you should pay off debt or contribute more to a 401, we encourage you to ask: How do I pay off debt AND save for retirement?

Asking the question in a new way opens up the possibility you can do both.

It takes a strategy and commitment to following through, but it is possible to pay off debt and save more retirement at the same time.

Here are a few suggestions on how to make this happen:

  • Pay off high-interest debt first, while saving something for retirement. At least contribute enough to your 401 to get your match because thats FREE money. If you have an IRA, automate your savings and have money directly deposited when you get paid each month. This way youre paying yourself first.
  • Once youve paid off your high-interest debt, continue paying a bit over the minimum on any lower-rate credit cards or debt you have. Then, divert more money to fund an emergency savings account. If you want to avoid getting back into debt, you need access to cash.
  • When you have a good chunk of change in your emergency savings, increase your retirement savings. Increasing your contribution percentage just 2% each pay period may make a big difference in the amount of income you have at retirement. Continue paying down debt you have on time.
  • Once your debt is manageable or gone, try and max out your yearly 401 and IRA contributions. Keep saving money in your rainy day fund as well. Whatever you do, make sure you dont go back into debt.

Using A 401 Loan To Pay Off Debt

If you arent eligible for a hardship distribution and want to avoid the stiff tax penalties associated with cashing out your plan, you may have a third option. Some companies allow plan participants to borrow from themselves using a 401 loan.

These loans tend to carry a lower interest rate than alternative options, are not taxed and do not impact your credit score. Even if you have to pay an origination fee, the fee is likely lower than the tax penalties you would face from an early withdrawal. Yet there are some downsides to a 401 loan.

The most you can borrow against your 401 is 50% of your vested account balance, or $50,000, whichever is less. In other words, you cant just pull all of your retirement savings out. You can have more than one loan out at a time, but the total amount owed cant be more than the limit. Most 401 loans must be repaid within five years. If youre married, your employer may require your spouse to consent to the loan.

Plus, your employer may temporarily suspend new contributions into the plan until youve repaid the loan. That means that while youre paying back what youve borrowed, youre not adding anything else to the balance. The money you withdraw also doesnt have an opportunity to benefit from compounding interest, which could stunt your nest eggs growth. And if you separate from your employer before the loan is repaid, the IRS requires you pay the remaining loan balance in full within 60 or 90 days.

Initiate Your Rollover With Fidelity

Youre making great progress. Youve confirmed key details about your 401 plan and you have an IRA to transfer your money into. The next step is to initiate your rollover with Fidelity. Fidelity has two methods for requesting a rollover to another institution:

If you are rolling over your Fidelity 401 to an IRA at Fidelity, you can request a rollover online, through your NetBenefits account. For rollovers to another institution, youll have to call or use the form.

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Cashing Out Your 401k While Still Employed

The first thing to know about cashing out a 401k account while still employed is that you cant do it, not if you are still employed at the company that sponsors the 401k.

You can take out a loan against it, but you cant simply withdraw the money.

If you resign or get fired, you can withdraw the money in your account, but again, there are penalties for doing so that should cause you to reconsider. You will be subject to 10% early withdrawal penalty and the money will be taxed as regular income. Also, your employer must withhold 20% of the amount you cash out for tax purposes.

There are some exceptions to the rule that eliminate penalties, but they are very specific:

  • You are over 55
  • You are permanently disabled
  • The money is needed for medical expenses that exceed 10% of your adjusted gross income
  • You intend to cash out via a series of substantially equal payments over the rest of your life
  • You are a qualified military reservist called to active duty

How Does A 401 Plan Work

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When you contribute to a regular 401 plan, you are making pre-tax contributions from your paycheck. That means your money wont be taxed until you withdraw it, and if you take out a loan against yourself and pay it back in time, that wont be taxed either. Upon retiring, you will be required to pay taxes on the money you have withdrawn from your account. Well discuss all your options for pre-retirement 401 funding below, but well go over the 401 basics first.

The amount of taxes you pay will depend on your tax bracket at the time of withdrawal. This is important to note as it means that you could end up paying more in taxes on the money you withdraw from your 401 at retirement than you would have if you had just taken the money out of your paycheck and paid taxes on it upfront. You should also ensure that you do not withdraw more money than you anticipate needing after retiring.

Finally, once you begin vesting your 401 money, you might be barred from withdrawing for a while. If youre looking into 401 loans, your first stop would be to make sure this is not the current state of your affairs.

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Should You Lower 401 Contributions To Pay Off Debt

If you’re contemplating lowering your 401 contribution to pay off your debt, there are certain items to be aware of.

Saving money for retirement is crucial. If youre burdened with hefty balances, school loans or other debt, however, you may be tempted to cut back on your 401 contributions to pay off the debt first.

Lowering your retirement savings to shed your debt may, indeed, make sense in certain circumstances. Whether its the best move for you depends on a number of variables, including your age, the interest rate on your debt, the type of debt, and whether your employer matches part of your 401 contributions.

More than 77 percent of U.S. families carried some sort of debt as of 2016, the most recent year that the government published data from its Survey of Consumer Finances. New data is expected later this year.

Nearly 42 percent held mortgages or other debt secured by their primary home, 38 percent carried , while roughly 31 percent had automobile loans and 20 percent held education loans, which represented the largest source of households non-mortgage debt in dollar terms.

Is It Smart To Use My 401k To Pay Off Debt

If you find yourself drowning in debt, using your 401k to pay off debt may seem like a viable option. In this article, we will talk about the pros and cons of using this strategy.

To make an informed decision before you touch your retirement savings, you need to understand the ins and outs of your 401k plan and what it can do for you.

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You Might Not Pay It Off

One of the biggest concerns with borrowing from your 401 is the fact that you just might not pay off the loan. Bergman points to study from Deloitte, indicating that defaults might drain as much as $2 trillion from Americans 401 account balances over the next 10 years.

For a typical borrower, this could mean a loss of $300,000 in retirement security over the course of a career. That could be a big blow to a saver especially if you cant contribute to your 401 while you have an outstanding loan.

When you dont pay back your 401 loan, youre subject to taxes and a 10% penalty if youre under the age of 59 ½, says Bergman. Thats a big blow.

Costs Associated With 401 Loans And Withdrawals

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We mentioned some costs associated with taking out a loan or making a withdrawal from your 401 account. These include taxes and penalties.

If you take out a loan from your 401, you will have to pay interest on the loan. The interest rate is usually lower than the rate you would pay on a personal loan, but it is still worth considering. Additionally, if you withdraw from your 401, you will have to pay taxes and penalties on the amount.

The tax rate will depend on your income level and the type of withdrawal you made. For example, if you take out a hardship withdrawal, you may have to pay an additional penalty if the amount exceeds $10,000, and you wont be able to pay it back, only contribute to your 401 later. Also, if you are under the age of 59 ½, you will likely have to pay a 10% penalty on the amount you withdrew.

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Borrowing From Your 401k To Purchase A Home

While it may be tempting to borrow from your 401k plan to purchase a home, understand that you will more than likely be paying a higher interest rate to pay back your 401k loan than you would on a traditional home loan.

Some people borrow from their 401k account for a downpayment on their primary residence. While a 401k loan is a quick way to get a down payment, keep in mind that you will now have a mortgage and 401k loan payment each month that may be difficult to sustain.

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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Important 401 Withdrawal Rules

401 withdrawal rules depend on your age and whether you have a traditional 401 or a Roth 401. These two factors will determine whether you have to pay income taxes and penalty fees.*

Before 59½

Taking money out of your 401 plan early is typically considered a premature withdrawal. This means that you will have to pay income tax on the withdrawn funds, along with an early withdrawal penalty of at least 10%. However, the penalty fee may be waived if your plan allows hardship withdrawals for expenses like medical bills, higher education expenses, buying a home, or if you have become disabled.

So, is it worth it to make a withdrawal before the age of 59½ to pay off debt? Lets look at an example: Imagine you take $50,000 out of your 401 to pay off your debt. You will immediately lose $5,000 due to the early withdrawal penalty, and you still owe income tax on the total $50,000. The 2021 income tax rate for a single individual making $100,000 was 24%, that means you would have to pay an additional $12,000.

In short, you are effectively paying $17,000 for the privilege of withdrawing $50,000 to pay off debt.

After 59½

The 10% withdrawal penalty fee is waived after the age of 59½, but you still have to pay income tax on withdrawals if you have a traditional 401. Withdrawals will be tax-free for those who have had a Roth 401 for a minimum of 5 years.

However, a Roth 401 would allow you to withdraw and use the entire $50,000 to pay off debt.

When It Doesnt Make Sense To Use A 401 Loan

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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.

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Reasons To Borrow From Your 401

The top reasons to borrow from your 401 loan include:

  • Its fast and convenient, especially since there are no lengthy applications or credit checks required. Youll then get access to the funds within a few days.
  • Theres repayment flexibility, including being able to repay the loan faster with no prepayment penalty. Some plans even allow payments to be made through payroll deductions.
  • There is technically no cost to take out a 401 loan for short-term needs. When you specify the investment account from which you want to borrow money, those investments are liquidated for the duration of the loan. So, you wont lose any positive earnings that would have been produced by those investments. There is a cost advantage equivalent to the interest rate charged on a comparable consumer loan minus any lost investment earnings on the principal you borrowed.
  • The loan repayments go back into your accounts investments, and you even repay the account a bit more through interest.
  • Like personal loans, you can use 401 funds for several things including:

    • Household bills and expenses
    • Moving expenses

    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.

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    Doing The Math With An Online Calulator

    A second way to look at the question is mathematically. Often thats the best tactic. The trick is finding a way to compare the different options that youre considering.

    In this case, Amy is really asking about her net worth three years from now. Remember that increasing assets or reducing debts improves your net worth.

    She can use one of the calculators that are available to determine what will happen to the two accounts under different circumstances. One of my favorites is at Bankrate.com. Her goal is to figure out what the amount due on her credit card and what her 401k balance will be in 3 years.

    Amy will be creating two different scenarios. In one, shell stop contributing to the 401k and use $400 to pay off debts. In the other, shell continue to contribute to her retirement and only pay off $50 per month.

    Try to make the comparison as neutral as possible. The assumptions that you make in creating the examples can predetermine the outcome. Especially in longer time periods.

    To really do it right, she should take the balances under each scenario and calculate what her net worth would be. If thats too complicated, then simply compare the amount of debt paid off versus the amount her 401k would increase.

    Related: 13 Personal Finance Calculators Everyone Should Use

    Consider A Personal Loan

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

    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.

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