Friday, November 25, 2022

Should I Use My 401k To Pay Off Debt

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Why Focusing On Retirement Generally Works

Should I Use My 401k To Pay Off Debt?

Retirement plans and emergency savings are both critical pieces of your overall financial puzzle, and retirement should be a major priority, as a rule of thumb. Dollars invested early on can have an exponential impact on retirement earnings, Lynch said, due to compound returns and market gains over time.

Calculate how much your current and any additional savings could be worth by retirement age with the U.S. Department of Labors Lifetime Income Calculator.

The True Cost Of A 401 Loan

Any money you borrow from your retirement fund misses both market gains and the magic of compound interest.

Just imagine taking out a five-year 401 loan during this current bull market at 30 or 35 years old it could severely impact your future nest egg, says Malik Lee, a certified financial planner at Henssler Financial in Kennesaw, Georgia.

According to Vanguards 401 loan calculator, borrowing $10,000 from a 401 plan over five years means forgoing a $1,989 investment return and ending the five years with a balance that’s $666 lower.

But the cost to your retirement account doesnt end there. If you have 30 years until retirement, that missing $666 could have grown to $5,407, according to NerdWallets compound interest calculator .

Moreover, many people reduce their 401 contributions while making payments on a loan from the plan. In fact, some plans prohibit contributions when a loan is outstanding. This further damages retirement plans.

Reasons People Borrow From Their 401k

There are many reasons people dip into their retirement funds early to pay off debt but there seems to be several common reasons people are willing to take this action.

  • Using your 401k to pay off debt
  • With the high-interest rates associated with , many people feel it is worth it to take money out of their retirement savings to pay off their cards.
  • Using your 401k to pay off student loans
  • Student loans seem to stick around forever. Most people are sick and tired of paying on their student loans each month and decide to pay them off, once and for all.
  • Using your 401k to purchase a car
  • Believe it or not, people love vehicles so much they are willing to borrow from their retirement to get a reliable vehicle or worse yet, their dream car.
  • Borrowing from your 401k to pay off your mortgage or buy a house
  • The psychological benefit that comes with living without a mortgage is something that appeals to many people. Using their retirement savings to pay off their mortgage can give people a feeling of freedom.
  • With all the different reasons people give as to why they borrow or take money from their 401k to pay off debt, are any of them good ideas?

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    Borrowing Against Your 401 Is It Ever A Good Idea

    Many full-time and part time employees have the benefit of a company-matched retirement plan, referred to as a 401 for the part of the tax code authorizing it. These tax-deferred packages are the principal retirement vehicle for just over half of people in the United States. Americans put away about 6% of their pay in 401 plans to receive employee matching and tax breaks.

    One feature many people dont realize about 401 funds is that the account holder can borrow against the balance of the account. About 87% of funds offer this feature. The account holder can borrow up to 50% of the balance or $50,000, whichever is lower, but the whole amount must be repaid within 5 years. Theres no approval process and theres no interest. Its basically a loan you give yourself, and is a popular enough option that 17% of millennial workers, 13% of Gen Xers and 10% of baby boomers have made loans against their 401 accounts.

    Despite these benefits, borrowing against a 401 is a risky proposition. There are harsh penalties for failure to repay and taking money away from retirement savings is always risky. Borrowing from a 401 account should not be a decision that is made lightly.

    As with most financial moves, there are benefits and disadvantages to borrowing from a 401. It can be difficult to sort through them, particularly if your need for money is acute and immediate. Before you borrow from a 401, though, ask yourself these four questions:

    How Much Can I Borrow From My 401k

    Should I Use 401k Loan To Pay Off Debt

    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.

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    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.

    K Plan Early Withdrawal Penalty Exceptions

    According to the IRS, several exceptions allow you to take money out of your 401k before the age of 59 1/2. The following are qualifying exemptions:

    • Death
    • If you die early, the government will let your beneficiaries access your retirement account without penalty
  • Disability
  • If you have a total and permanent disability, as defined by the IRS, you may access your funds
  • Medical Expenses
  • If unreimbursed medical expenses are more than 10% of your adjusted gross income, you may access your 401k to pay for the medical bills without paying a penalty
  • Military Service
  • If you are reservist called to active duty, certain distributions are eligible for the exemption
  • **Be sure to check with a tax professional before taking money out of your 401k plan to ensure tax laws have not changed.

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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
    • Funeral

    Generally, the IRS relies on the employer to ensure the employee takes distributions related to the hardship.

    What Could Be The Cost Of Missed Retirement Savings

    Should I use my 401k to pay off debt? W/Prince Dykes

    A report from the National Institute on Retirement Security found that 95% of millennials arent saving enough for retirement. And a 2017 study from Wells Fargo shows that other generations arent faring much better. So if youve been trying to beat the odds and put aside adequate savings for retirement, taking out a 401 loan can be a triple whammy.

    First, some plans dont allow participants to make plan contributions while they have an outstanding loan. If it takes five years for you to repay your loan, that could mean five years without adding to your 401 account. During that time, you may be failing to grow your nest egg and youll miss out on the tax benefits of contributing to a 401.

    Next, if your employer offers matching contributions, youll miss out those during any years you arent contributing to the plan. Loan repayments arent considered contributions, so if the employer contribution is dependent upon your participation in the plan, you may be out of luck if you cant make contributions while you repay the loan.

    And finally, your account will miss out on investment returns on the money youve borrowed. Although you do earn interest on the loan, in a low-interest-rate environment you could potentially earn a much better rate of return if the money was invested in your 401.

    What are the tax benefits of 401s?

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    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.

    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.

    Read Also: How To Transfer 401k Without Penalty

    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.

    Assess Your Current Financial Situation

    Should I Use My 401k to Pay Off Debt? Here

    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.

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    Should You Pay Off Your Car Or Invest

    Whether you should pay off your car or invest depends on the loan’s interest rate and your overall financial situation. Paying off the loan early gives you full ownership of your vehicle, which can come in handy if you need to sell it quickly. If you have high-interest debt, you may want to pay that off before you pay off your car or invest. If your car loan has a high interest rate, it would make sense to pay it off before you invest.

    Should I Take Money Out Of My Ira To Pay Off Debt

    11 Minute Read | September 24, 2021

    If youre in the middle of paying off your credit cards, car loans or student loans, you know that every extra dollar toward debt helps. But if youre starting to consider your retirement fund as a way to dig yourself out of the hole, hold up!

    While it may be tempting, taking money out of an IRA to pay off debt is a terrible idea. Not only can that money come with outrageous early withdrawal penalties and taxes, but its also stealing from your future self. Weve broken down what happens when you cash out a retirement fund early, and well tell you how you can pay off debt without raiding your IRA.

    Read Also: What Is An Ira Account Vs 401k

    What About 401 Loans

    Another mistake people make is taking out a 401 loan to pay off their debtbut you end up having to pay yourself back with interest. Yuck! And 401 loans can backfire quickly. If you lose your job, that loan needs to be paid back within 60 days. If its not, youll be forced to payyou guessed ita 10% penalty, plus taxes. But the truth is, you cant borrow your way out of debt, so you should avoid loans altogether.

    Make A Debt Repayment Plan

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

    Once youre meeting your minimal debt obligations, have built up your emergency savings and have maximized the free money you get to save for retirement, it makes sense to take whats left over each month and consider a blend of debt payments and retirement investments.

    But which to prioritize first? Your calculator might tell you to pay off the highest-interest, highest-balance debts first and then to invest once youre left with debts that will cost less in interest than market performance will earn.

    While that may make the most sense mathematically, human nature and cognitive biases sometimes prevent us from making the most logical financial decisions, says Jeff Kreisler, head of behavioral science at J.P. Morgan Private Bank. One example: something behaviorists call hyperbolic discounting. We incorrectly discount the value of cash in the future.

    Wed rather have $10 today than get $15 in a month. Thats because were emotionally connected to our present, says Kreisler. Ever stronger, for many people, is the pull of loss aversion. We hate losing money. We hate it so much that we get angrier about paying a $20 parking ticket than we are happy when we find a $20 bill. Oftentimes, wed need to win double the amount wed lose to negate the pain of loss.

    Thats why Desmond Henry, a Kansas-based certified financial planner , thinks its best for young people to prioritize saving for retirement over paying down most kinds of debt .

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    How To Use A Retirement Account To Pay Off Credit Card Debt

    President of Quest Education, teaching business owners about funding, paying off debt, and investing in alternative assets.

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    Many Americans have both credit card debt and a retirement account, such as a 401 plan or individual retirement account . This means they are likely losing money faster than they are making it.

    According to WalletHub’s Credit Card Landscape Report, interest rates average 17.98% for new credit card offers and 14.58% for existing accounts. In regard to retirement accounts, one commonly hears that investors can expect an average 6%-7% annual return in the stock market over the long term. Losing 17.98% per year on a portion of your money and then making 7% per year on another bucket of money means you could be going backward financially. However, there is a lesser-known option to fix this problem using your retirement account.

    Some people consider taking funds out of their retirement account only to discover that withdrawing money from the IRA/401 plan would cost 20%-35% in penalties and taxes to the IRS. That would mean if a person takes out $20,000 from their retirement account to pay off credit card debt, there could be up to $7,000 in penalties and taxes paid.

    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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