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Look Into Debt Consolidation
If you have too many high-interest rate credit cards, debt consolidation is another option instead of a 401k loan. Again, not an ideal solution, but it is an option.
Debt consolidation involves rolling one or multiple debts into another form of financing. This is usually in the form of a personal loan that you pay back monthly. Debt consolidation usually offers a lower APR than what youre currently paying helping you pay off the debt faster and pay less interest.
Taking Money Out Of A 401 Pay Debt: Does It Make Sense
To determine whether withdrawing from your 401 makes sense, crunch the numbers. Compare the interest rate on your debt with the tax penalties you would face. High interest rates on significant debt may necessitate drastic measures. If youre considering a 401 loan, make sure you have a disciplined financial plan. 401 loans can also be a powerful option for eliminating high-interest debt, but they can still set you back.
Be honest about where you stand, too. If you have a relatively large starting balance, using your plan might not make a huge difference in the long run. If youre already behind on saving, however, taking money from your 401 could create a big problem come retirement. There is also an emotional element to borrowing against your retirement. Once you tap those funds, it could be tempting to do it again.
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Why You Should Cash Out Non
Heres the deal: You shouldnt be investing until youre debt-free and have a fully-funded emergency fund. Why? Because you want to make sure you can put food on the table and take care of emergencies when they pop up before you start saving for the future. And as long as youve got part of your paycheck going to student loans, credit cards or car payments, you cant truly build wealth. So, if youre wondering whether to pay off debt or save for the future first, the answer is always pay off your debt.
Investing while youre in debt is a zero-sum game. Any money you might earn from your investments is pretty much canceled out by the interest youre forced to pay on your debt. Those investments wont help you increase your net worth if youve got a pile of debt that keeps tipping the scale the other way.
Think about it this way: Would you take out a student loan to invest in a mutual fund? Or if you had a paid-for car, would you borrow against your car to buy single stocks? Of course not! Borrowing money to invest doesnt make any sense. And thats basically what youre doing when you have money sitting in investment accounts but you still have debt. Its like having a cookie that you want to save for later. But before you can put it in a jar, someone else takes a huge bite out of it. That someone is debtbecause debt is a cookie monster.
Should You Cash Out Your 401k To Pay Off Debt
Before we make this decision, it is important to understand why our retirement accounts are so important. It is so easy to lose focus on why we are investing when retirement seems so far away. The temptation to take from our retirement to fix our current problems is a strong force. We want to stop our suffering in the here and now. I get it. Unfortunately, our future selves will pay the price for fixing our current struggles with this strategy.
If you pull money out of your 401k to pay off a debt, it is important to take into account the specific impact this will have on your investments.
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Don’t Take A Distribution Take A Loan
As mentioned, early withdrawals have serious tax ramifications. So a distribution is not the preferred strategy. Plus, taking money out of your 401 permanently means that you lose out on the chance for those funds to grow over time which is the whole point of stashing away money into your retirement nest egg. You want those funds to appreciate over the years and to be there for you once you stop working.
So again, the borrowing route is more desirable, because it will force you to replace the money you take out.
But if you’ve already retired, you can’t borrow money from an employer-sponsored retirement account, such as a 401, 403 or 457 plan. So this strategy will only work for people who are still gainfully employed and whose retirement plans at work permit borrowing.
OK, back to our example. You’ve got $20,000 worth of credit card debt and that 15 percent interest isn’t making it any easier to pay off.
Your credit card company only requires that you pay 2 percent of the outstanding balance each month. In other words, your required minimum payment is $400 per month. At that rate, you’ll pay off your $20,000 balance in 6 years and 7 months. And over that time, you’ll pay a total of $11,577 in interest.
To avoid this scenario, take a loan from your retirement plan at work, but only if:
- You can set up a repayment plan that is three years or less
- You reasonably confident that you will remain with the same company during that three-year period
Free Planning Tool
Should I Contribute To My 401 Or Pay Off Debt
Whether to pay off debt first or contribute to a 401 is an important question to evaluate for those with debt, but still worried about saving for retirement. There are many considerations when pondering this question, such as how much money to direct towards your debt and how much towards retirement, and when!
First, well lay out some information to help you understand whats involved in making this decision. Next, well take a unique approach to this complicated question and look at your mind and your money. Finally, well investigate how to decide whether to contribute to your 401, pay off debt, or do both.
Also Check: When Can I Take Money Out Of 401k
The Best Method To Pay Off Debt
The absolute best way to take care of that suffocating debt is to leave your retirement alone.
Do not rob your future self to pay the debts of your present self.
While you are young and healthy, you should be using this time to pay off your debts as soon as humanly possible. Pick up a side hustle, and sell everything you no longer use. Host yard sales, get on a budget and bear down to destroy this debt.
Do not pay the extra 10% tax penalty by pulling your money out early in any circumstance. There is always an alternative to taking from or borrowing from your 401k. However, you are an adult and you are going to do what you want. If you are determined to take from your retirement, at least take a loan from it instead. Force yourself to repay your future self with interest.
Should I Borrow From My 401k Account To Pay Off Debt
An argument for borrowing from your 401k is to eliminate a large debt with a high-interest rate. Say for instance your $40,000 debt is on a credit card at 16% interest. On the outside, it may seem like a no-brainer to forfeit the 8% a year on your investment instead of paying 16% interest on that debt.
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What Are The Rules For 401 Withdrawal
Tax-deferred retirement accounts like 401s, 403s, and others were designed to encourage workers to save for retirement, so the rules arent super friendly for those who want to make a withdrawal before age 59½.
But depending on your financial situation, you may be able to request what the IRS calls a hardship distribution .
Employer retirement plans arent required to provide hardship distribution options to employees, but many do, so it may be worth checking with your HR department or plan administrator for details on what your plan allows.
According to the IRS, to qualify as a hardship, a 401 distribution must be made because of an immediate and heavy financial need, and the amount must be only what is necessary to satisfy this financial need. Expenses the IRS will automatically accept include:
Certain medical costs.
Costs related to buying a principal residence.
Tuition and related educational fees and expenses.
Payments necessary to avoid eviction or foreclosure.
Burial or funeral expenses.
Certain expenses to repair casualty losses to a principal residence .
You still may not qualify for a hardship withdrawal, however, if you have other assets you could draw on or some kind of insurance that will cover your needs. And your employer may require documentation to back up your request.
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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.
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Withdrawing Before Age 59
For individuals 59Â½ years old and younger, the early withdrawal penalty is 10 percent. Youll also have to pay income tax on what you withdraw, which in 2021 can range from 10 to 37 percent.
Plus, the withdrawal can impact your income taxes in one other way. Making annual plan contributions to your 401 reduces your taxable income. So if you withdraw a significant amount from your 401 account, it could push you into a higher income tax bracket and you might owe more in taxes.
Lets look at an example of what a withdrawal can potentially cost you when youre 59Â½ years old or younger.
Say you take out $40,000 to pay off a high-interest credit card and a student loan. Right away, youre charged the 10 percent penalty, which is $4,000. Next, youll owe income tax on that $40,000. If youre a single-income earner who makes $40,000 in 2021, your annual salary is in the 12 percent income tax bracket. However, this $40,000 withdrawal will put you in the next bracket with a tax rate of 22 percent, which means an additional $8,800 of your withdrawal will go toward taxes.
So, that $40,000 youre taking out will cost you $12,800 in taxes and fees, leaving you with $27,200 to apply to your debts.
Are You Eligible To Withdraw Money From A 401
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 1/2
- 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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What Are The Different Types Of Retirement Accounts
Before considering the costs of early withdrawal, its important to understand the difference between traditional and Roth accounts. Each is handled differently in case of early distribution.
A traditional retirement account is contributed to with pre-tax dollars. Contributions and earnings will be taxed when distributed.
A Roth retirement account is contributed to with taxed dollars. Contributions and earnings will be distributed tax-free.
You should also know the difference between the two main types of retirement accounts 401 and IRA.
A 401 is an employer-sponsored plan typically made up of funds chosen by your employer. If you have automatic contributions from your paycheck into a retirement account, you likely have a 401 plan. Many employers also offer a Roth option.
An IRA, or individual retirement arrangement, isnt employer-sponsored. You open it yourself and choose the funds that make it up. Traditional and Roth options are available for your IRA. If you need help opening an account, check out this NerdWallet article on how and where to open an IRA.
Normally, retirement accounts cant be distributed until after the age of 59Â½. If you withdraw money early, youll have to pay taxes and penalties. Youll also miss out on the biggest benefit of investing future gains.
What Is A 401
A 401 plan is a retirement savings plan. The money you contribute to your 401 plan is not taxed until you withdraw it in other words, your savings will be tax-deferred as they grow.
There are two types of 401 plans: Traditional and Roth. With a traditional 401, you will not pay taxes on the money that you contribute until you withdraw it. On the other hand, with a Roth 401, you pay taxes on the money you contribute, but you dont have to pay taxes when you withdraw it in bulk. Another difference between a traditional and Roth 401 is that the former lets you take a loan from your account. With a Roth 401, you cannot touch the savings until youre retired.
When To Use Your 401 To Pay Off Debt
You should only withdraw from your 401 to pay off debt in extreme circumstances. Using a withdrawal to pay off a low interest home mortgage or student loans does not make financial sense due to penalty fees and taxes.
However, you might consider making a withdrawal to pay off loans or credit card debt with a high interest rate . Youll have to do some math before you decide whether or not its worth it. Keep this in mind, not only are withdrawal penalties and taxes a large expense, but any money you take from your 401 means less money saved for retirement.
What The Pros Say: Should I Contribute To My 401 Or Pay Off Debt
Theres no easy solution to whether you should contribute to your 401 or pay off debt. Heres what several financial advisors recommend to their clients.
Grant Bledsoe, CFA, CFP, Portland financial planner and the founder of Three Oaks Capital Management reminds us that each of us has a different comfort level with debt. Some people are okay borrowing great sums for a home, business, auto and other large purchases. Whereas others cant sleep at night with the smallest amount of debt. If youre one of those individuals that abhors debt, feels terrible with the debt hanging over your head, then pay it off as quickly as possible.
On the other hand, Joseph A. Carbone, Jr., CFP®, Founder and Wealth Advisor at Focus Planning Group Group doesnt differentiate between those that can tolerate higher debt levels and those that cant. Carbone recommends paying down debt first for all. He suggests paying off the highest interest rate debts first and continue until all of the debt is paid off. Carbones rationale is that in most cases, as we previously discussed, the interest rates on the debt is higher than that of the expected returns on your investments. Thus, carrying debt and paying into your 401 equates to a net loss.
If all of your debt carries high interest rates, then pay it off aggressively first and only contribute the minimum required to your 401 to secure the employer match. After youre debt free, you can .
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