Should You Take Money Out Of Your 401(k) To Pay Off Debts?

It’s hard to put a good face on debt. While some experts in personal finances believe there is both good debt and bad debt, most people get into trouble with bad debt – credit card debts, personal loans, lines of credit and medical bills. If you’re trying to cope with big debt and have a 401(k) it can be mighty tempting to use some of that money to clear those debts and get a fresh start. But before you do so, there are some things that you should take into consideration

It will be taxed

The first thing to consider is that unless you can qualify for what’s called a hardship exception, you will have to pay taxes on the money that you withdraw plus a 10% withdrawal penalty. Hardship exceptions include immediate and substantial medical expenses, costs related to buying a home, tuition and educational fees related to it, payments required to prevent eviction or foreclosure, funeral or burial expenses and some expenses required to repair damages to your principal residence.

If you don’t qualify

If you haven’t had any of these hardships, we’ll assume that 35% of money you take out of your 401(k) will go to Uncle Sam. For the purposes of this example, we will also say that you need to get $10,000 to get pay off your debts.

There’s a formula

There is a formula you could use to determine how much money you will have to withdraw the get the $10,000 you need. The net/net is that you would need to withdraw $15,385 to have the $10,000 you need to pay off your debts.

The good news

The good news is that you will no longer have those debts hanging over you and you will no longer have to make those ugly payments every month. Unfortunately, there are costs that are more difficult to see. This is because they won’t happen until you retire.

An example

If you were to leave that money in your 401(k) and earn 5% interest a year, your money would double every 14 years. If you were to retire at 66 or 67, it would have doubled twice and would have grown to around $60,000. Many experts on retirement say that you can safely withdraw about 2% of your principal each year after you retire. The $60,000 would translate into about $1800 per year or $150 a month for the remainder of your life and you would still have the original $60,000.

Take it as a loan and not a withdrawal

A better option might be to take out a loan from your 401(k) instead of a withdrawal. Since it’s a loan you wouldn’t be required to pay taxes on it. You will have to pay interest on the money you borrow but it should be much less than the interest you’re paying on your credit cards. And here’s the really good part. You’re basically paying interest to yourself.

What to watch out for

If you choose to take the money as a loan, there are some things to be aware of. For example, with most 401(k) plans, if you lose your job, you must repay the entire loan amount. Second, you need to make sure you pay back the money within five years or again, it will be treated as ordinary income and taxed accordingly.

A better option

Many people have found that a better option than borrowing from their 401(k) is to get rid of their debts through debt settlement. This is the only option that can reduce your debts to help you become debt free in 24 to 48 months. Plus, if you choose a good debt settlement company such as National Debt Relief, you’ll have a very affordable payment plan and your retirement money will still be sitting in your 401(k) quietly earning interest.