Friday, November 18, 2022

Should You Withdraw From 401k To Pay Off Debt

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Should I Use 401k Money To Pay Off Debt And Buy A Home?

While avoidable penalties and fees are painful, another issue is that you may deprive yourself of long-term growth if you borrow or withdraw from your 401.

You may miss out on potential investment growth if you take money out of your 401. The longer your money is in your account, the more exposure you have to market experience and potential gains.

And if your employer matches a percentage of your personal 401 contributions and you stop contributions, you may be missing out on those matching contributions.

Together, these may cause harm to your future finances and jeopardize your long-term financial security.

Doing The Math With A Regular Calculator

Even if Amy doesnt have access to a computer, a simple comparison can be created using a calculator. To estimate how much debt is to be paid off, shell need to create a list with 4 columns. The first column is for the beginning credit card balance. To that shell add the second column which shows the amount of interest owed for that month. She can calculate that from the amount owed multiplied by the annual interest rate being charged divided by 12.

From that total, shell subtract column three, which is the amount of the payment for the month. The result is column 4, the ending balance, which is the beginning balance for the next month.

A second table can be created for the 401k plan. The first column is for the beginning balance. To that will be added the second column and the third column . The total will be the ending balance in column 4. And, once again, the ending balance from one month will be the beginning balance of the following month.

Dont forget to include any employer matching contributions. They can make a big difference in your account growth. She can compare the results to see which would work better for her.

And if it turns out it makes more sense for her stop contributing to her 401k until her debt is paid? If she has a good understanding of how to maximize her 401k contributions, she can hopefully boost her retirement savings once she is debt free.

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Reviewed May 2021

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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.

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Using Your 401 Funds Might Make Sense For Debts With High Interest Rates

Not all debts are created equal. For example, credit cards have high interest rates around 20 percent, and failing to pay your bills in full will only put you further in debt. In a high-interest situation like this, cashing out a portion of your 401 might make sense, but it’s important to run the numbers to make sure you can actually get yourself in the green. You will also want to explore all other options before deciding to do this.

In most cases, you should not cash out your 401 to pay off low-interest debt since it likely won’t be in your best financial interest.

Consider A Hardship Extension

401K To Pay Off Credit Card Debt : Should You Take Out A 401 K Loan To ...

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.

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    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. When it comes to things like refinancing your student loans or auto loans, you might be able to get a lower interest rate than youre currently paying.

    This may be 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 20 to 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 .

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

    11 Minute Read | December 14, 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.

    Calculate How Much Of Your Retirement Is At Risk

    Part 2: Withdrawing from 401k to Pay Off Debt During COVID-19

    Having a 401k is crucial for your financial future, and the government tries to reinforce that for your best interest. To encourage people to save, anyone who withdraws their 401k early pays a 10 percent penalty fee. When, or if, you go to withdraw your earnings early, you may have to pay taxes on the amount you withdraw. Your tax rates will depend on federal income and state taxes where you reside.

    Say youre in your early twenties and you have 40 years until youd like to retire. You decide to take out $10,000 to put towards your student loans. Your federal tax rate is 10 percent and your state tax is four percent. With the 10 percent penalty fee, federal tax, and state tax, you would receive $7,600 of your $10,000 withdrawal. The extra $2,400 expense would be paid in taxes and penalties.

    The bottom line: No matter how much you withdraw early from your 401k, you will face significant fees. These fees include federal taxes, state taxes, and penalty fees.

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    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.

    The Math Behind Using Your 401k To Pay Off Debt

    Lets take a look and see what would happen if David did take money out of his 401k plan to pay off bills. To illustrate the point well need to make some assumptions. Assume that hes 30 years old and expects to retire at age 65.

    For David to end up with $21,000 to pay off his bills, hed need to withdraw $28,000 from his 401k plan. The reason is that hell be paying 25% to cover the penalty on early withdrawal and taxes. The penalty is 10% of the money withdrawn. Hell also pay ordinary income taxes on the money. We used the 15% income tax bracket .

    David mentions a hardship withdrawal. While the 401k plan might allow such a distribution, the chances of being granted a hardship that will avoid IRS penalties is not too great. The most common reason granted is for medical bills. Just charging too much on your credit cards doesnt cut it.

    How much will that withdrawal cost David when hes ready to retire? Well, if he left that $28,000 in the 401k plan and it just earned 5% each year until he was age 65, it would be worth $154,000 . When he retired, if David never touched the principal and just took the interest earned, hed receive a check for $641 every month for the rest of his life.

    So one way to look at it is that it will cost him $154,000 or $641 per month when he retires to pay off his current $21,000 debt. Thats a pretty expensive payoff.

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    What Are The Costs Associated With 401 Loans

    You may be able to avoid paying an early withdrawal penalty and taxes if you borrow from your 401 instead of taking the money as a distribution. But 401 loans have their own set of rules and costs, so you should be sure you know what youre getting into.

    There are some appealing advantages to borrowing from a 401. For starters, if your plan offers loans , you might qualify based only on your participation in the plan. There wont be a credit check or any impact to your credit score even if you miss a payment. And borrowers generally have five years to pay back a 401 loan.

    Another plus: though youll have to pay interest , the interest will go back into your own 401 account not to a lender as it would with a typical loan.

    You may have to pay an application fee and/or maintenance fee, however, which will reduce your account balance.

    Of course, a potentially more impactful cost to consider is how borrowing a large sum from your 401 now could affect your lifestyle in retirement. Even though your outstanding balance will be earning interest, youll be the one paying that interest. Until you pay the money back, youll lose out on any market gains you might have had and youll miss out on increasing your savings with the power of compound interest. If you reduce your 401 contributions while youre making loan payments, youll further diminish your accounts potential growth.

    There may be similar consequences if you default on a 401 loan.

    There’s A Chance Of Debt Forgiveness

    Should You Pay Off Credit Card Debt With Your 401K?

    While this comes with a giant asterisk, some people should consider the possibility of debt forgiveness. For example, if you’re involved in a student loan forgiveness plan such as Public Service Loan Forgiveness, follow that program’s requirements rather than paying extra on those loans.

    If there’s any chance part of your debts could be wiped out through loan forgiveness or cancellation, focus on retirement until forgiveness is official. However, beware that securing loan forgiveness isn’t always a smooth path. You’ll need to be prepared in case you’re still obligated to pay the debt.

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    What Are Some Ways Of Minimizing Risks To Your Retirement

    If you decide using a 401 to pay off debt is your best option, here are a few things that could help you lower your financial risk.

    Not using your high-interest credit cards once you use your 401 to pay them off. If you continue to use your credit cards, and then have credit cards and the 401 loan payments to make every month, you could end up in even more financial trouble.

    Continuing to make contributions to your 401 while youre repaying the loan at least enough to get your employers match.

    Not overborrowing. Creating a budget could help you determine how much you can comfortably pay each quarter while staying on track with other goals. And try to stick to taking only the amount you really need to dump your debt and no more.

    Can I Cash Out My 401k While Still Employed

    If your 401k plan is sponsored by your current employer, you can not access this money until you leave employment or suffer a major hardship. If you have an old 401k plan from a previous employer, you can cash this out or take the cash back from it but you may be subject to an early withdrawal penalty.

    Also Check: Can A Roth Ira Be Rolled Into A 401k

    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.

    Remember That You Can Do Both

    Should I Pull Money From My 401(k) To Pay Off Debt?

    Let’s not forget the third option: splitting the difference. The issue of debt payoff versus retirement doesn’t have to be an either/or proposition.

    “If you are like most people, you need to balance debt paydown and retirement savings,” 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 employer’s 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. It’s impossible to provide a one-size-fits-all answer, given the wide variations in financial circumstances and emotional responses to debt.

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