Should I Use My 401K to Pay Off Debt?

You’ve been faithfully investing in your 401(k) for years. With your spending, you weren’t as forward thinking, so you’ve racked up considerable debt. If your 401(k) is like a savings account for your future, why can’t you use it to pay off your outstanding debt?

You can, but the real question is, should you?

What Is a 401(k)?

A 401(k) is a company-sponsored retirement program that allows employees to make pre-tax contributions for investment. Employees have total control over the funds. Most 401(k) plans offer a mix of stocks, bonds, and money market accounts with varying levels of risk. Many companies offer contribution matching, so if an employee invests $2,000 a year into his or her 401(k), the company will match it and put in $2,000, usually up to 3% of the employee’s yearly salary.

The employee can put in more but the employer won’t match it. A contribution limit exists because the money is pre-tax, so the IRS isn’t collecting taxes on it. In 2018, the limit that could be put into a 401(k) increased to $18,500 to keep retirement savings on par with the raises in the cost of living.

Cashing Out a 401(k) to Pay Bills

Cashing out your 401(k) is always a bad idea. With the cost of living guaranteed to go up and the state of Social Security continually in question, saving money for your retirement should be one of your top priorities. Anything you have in there should stay put so it can grow.

If you do decide to cash money out of your 401(k), you’ll be hit with an immediate 10% early withdrawal penalty if you’re under 59 ½, and you’ll have to pay income taxes on it as well.

It took a long time to build up the money in your retirement account, and it would take many years for you to catch up again. During that time, you’d be missing the interest that your money would’ve made by being invested. If you’re remotely close to retirement age, it’s likely you won’t fully recover the loss.

Most people who cash out money from their 401(k) do so because they’ve changed jobs. Perhaps it’s because it’s easier than rolling it over into a new account. It could be that it’s just too tempting not to cash the check. Remember, it’s not a bonus for finding a new job; it’s money you’ve been saving and should be put into another retirement account.

Borrowing Money from a 401(k)

You can borrow against your 401(k); however, you have to pay it back with interest. The good news is that the loan interest goes into your 401(k) account so you’re essentially paying yourself for the use of your money. Interest is typically the prime rate plus 1%, which is better than most credit cards or personal loans.

A loan on your 401(k) doesn’t affect your credit score, but it does have an impact on your retirement savings. The money that you took out is no longer earning money for you, which will be quite a bit of missed earnings if it’s a good year for the market. If you go bankrupt, 401(k) loans are difficult to discharge, and there are usually fees or penalties involved.

Loans are usually for a term of five years or less. If you leave your job for any reason during that time, you’ll have to pay off the loan immediately.

Other Options

You don’t have to dip into your retirement plan. There are many other good options for dealing with your debt while continuing to contribute to your 401(k). A loan on your 401(k) should be your last resort. First, look into the following options.

Debt Consolidation

This involves taking your high-interest debt and rolling it into a single, lower interest loan. It saves you money and helps you get your debt paid off faster. This can be done through a personal loan (a good choice because, unlike credit cards, they have fixed terms and fixed interest rates), a home equity loan, a mortgage refinance, or a transfer to a 0% credit card.

Debt Counseling

Consumer credit counseling organizations are typically nonprofit entities. They charge relatively low fees to help you get out of debt by negotiating your debt, as well as offering financial education and budgeting.

Debt Settlement

Debt settlement companies such as National Debt Relief help consumers negotiate their debt down to a final payment, saving them money. It takes patience, and the process can affect your credit negatively, but the savings on your debt can be significant.

Bankruptcy

Chapter 7 bankruptcy allows you to have your debts discharged and your possessions sold to pay your creditors. Chapter 13 sets up a limited payment plan that allows you to keep your things and pay your creditors a portion of what you owe. Bankruptcy will affect your credit negatively for up to 10 years for Chapter 7 and up to seven years for Chapter 13. The types of debt that you’re allowed to discharge cannot include student loans, child support, and most taxes.

Downsizing

If you own a home, it may be time to consider downsizing to a smaller home, a condo, or even an apartment to save on monthly costs.

Get a Second Job

Find something that fits your schedule and dedicate all your earnings to paying off your debt. When your debt is finally paid off, you’ll have two reasons to celebrate: no more debt and no more second job!

Get Out Of Debt Now

No matter how you choose to handle your debt, it ‘s important that you start to handle it now. Pushing it off will only make the problem worse. Instead, get started today and start getting out of debt sooner.