High-interest credit card debt can be a hole that is difficult to climb out of. With rates that can be 20% or higher, this makes it almost impossible to pay off on a limited income.
If you have a mountain of credit card debt, you may be tempted to borrow from your 401(k) retirement account to pay it off. In some situations, this may be ok, but there can also be serious implications for your retirement account.
Before you decide to borrow money from your 401(k) retirement account to pay off debt, be aware of the dangers and benefits.
What is a 401(k) Retirement Plan?
Employers that are for-profit companies will usually offer a 401(k) retirement account to their employees. This allows you to contribute pre-tax to your retirement, which reduces your current taxable income.
Since you don’t pay taxes now when you contribute, the money will grow on a tax-deferred basis until you are able to withdraw money at age 59 and 1/2 years old. At that point, you will be responsible for paying taxes.
401(k) plans provide a tax-advantaged way to save for retirement. They also allow the employer to provide a contribution match as a further incentive to the employee. Usually, if you contribute a certain amount per pay check, your employer will also match a small amount.
If you work for a non-profit company, they may offer a 403(b) retirement plan instead. These work the same way as a 401(k) with the exception being that they are designed for non-profits.
When Should I Borrow Money to Pay off Debt
Borrowing money to pay off other debt can be a slippery slope. Essentially, you are creating debt to eliminate another form of debt. This can work well to save money and reduce your overall debt when done correctly.
However, it can also create other issues and more debt if you are not careful. Cashing out your retirement account to pay off your house is probably not a great idea. This reduces your retirement nest egg and limits the amount of investment growth.
Borrowing money to pay off debt all comes down to the interest rates on both sides. It works best to borrow money at a low interest rate and use it to pay off a higher rate.
Credit card debt is a great example of this. Often times, they can have interest rates in the 20% to 30% range. If you can get a loan for 5%, you will significantly cut the amount of interest you have to repay. This helps to get out of debt faster and reach financial freedom.
How to Borrow Money from a 401(k)
There are two ways that you can borrow money from a 401(k) retirement account.
- Early withdrawal, provided that you are under the age of 59 and 1/2.
- 401(k) loan
Both of these options will impact your long-term ability to grow your money and save for retirement, so be aware of the downfalls. Taking money out of your 401(k) reduces the principal balance, which also impacts the amount of interest it can earn.
Depending on when you are planning to retire, this can can have a serious impact on your total savings at retirement. in some situations, though, it can make sense to use that money to pay off other debt.
401k Early Withdrawals
If you have a 401k with a sizeable amount saved up, you might be tempted to use it for other things. This should always be your last resort since you will be better off letting it sit until you retire.
For situations where you need the extra money for an emergency or to pay off a high interest loan, it is possible to make an early withdrawal.
An early withdrawal on a 401(k) means that you are taking a distribution before the official retirement age of 59 and 1/2. If you are older than 59 and 1/2 years, you can start to withdraw money at no penalty.
However, if you are younger, you will be faced with a 10% penalty fee plus having to pay income tax on the amount you withdraw. For me in Connecticut, I would have to pay the 10% fee plus my 6% income tax, for a total of 16%.
Hypothetically, to be beneficial to use this method to pay off debt, I would need to have debt that is at least 20%. I could withdraw money from my 401(k) and use it to pay off my credit card to save 4%.
To note, early withdrawal from a retirement account should be the very last option to access more money. At all costs, try to avoid touching your retirement savings to avoid tax penalties.
Pros
- Ability to access funds that you have already saved up
Cons
- 10% early withdrawal penalty plus having to pay income tax
- Drastically impacts retirement savings and overall growth for when you actually retire
- Tax implications for withdrawing and minimizes tax-deferred benefits
401(k) Loans
Another option is to borrow money from your 401(k) using a loan. A 401k loan allows you to take money out of your retirement account and repay it to yourself over a maximum of 5 years.
The exact rules may vary with your employer, but many plans allow you to borrow 50% of your retirement account, or up to $50,000, over 5 years.
One of the benefits is that you are essentially repaying yourself as you pay off your 401k loan. As you repay the loan, your principal payment plus interest is added back into your retirement account.
Be aware that the 401(k) loan is tied to your specific employer. If you leave the company, you will be required to repay the full amount of the loan. The penalty for not repaying the balance at that time is to be taxed by the IRS as an early withdrawal.
Pros
- Principal plus interest is repaid to your account
- Relatively low interest rates, usually at the prime rate plus one percent
- No credit check or impact to credit score
Cons
- Maximum repayment period of 5 years
- Leaving your company will require you to repay the balance or face an early withdrawal penalty
- It can seriously affect how much interest you earn in the long run and jeopardize your retirement savings
Which is Better?
If you absolutely need money to help pay off higher-interest debt, using your 401(k) could be an option. To minimize the impact on your retirement savings, my preference would be to use a 401(k) loan instead of an early withdrawal.
A 401(k) loan will impact your overall savings because you will miss out on the compound interest during that time period. An early withdrawal will permanently decrease your account value and decrease your interest earnings.
Using our compound interest calculator, here is a look at the impact of taking $10,000 from your 401(k).
- 401(k) Loan: A $10,000 401(k) loan at 5% for 5 years. During that time period, you will have to repay the full $10,000 plus an additional $2,762 in interest.
- Early Withdrawal: Withdrawing $10,000 early costs $1,600 in penalties, leaving you only $8,400. If you 40 when you take this loan, you could miss out on $54,275 in interest.
- Doing Nothing: If you had just left it and earned an average of 7%, you would have earned $4,025 in interest over 5 years.
As you can see, not touching your retirement account is the best because you will continue to make money without having to do anything. Taking a loan requires you to pay an extra $12,762 to “refill” you account to the previous level and you will still be sort by over a thousand dollars. Withdrawing early will cause you to miss out on over $50,000 in interest.
Alternative Ways to Pay off Debt
Instead of borrowing from your 401(k), there are better ways to pay off your high-interest debt.
If you have credit card debt, you can try to open a new credit card and use a 0% balance transfer. This will give you 12 to 18 months of zero interest to help pay off your debt. By focusing your payments during that time period, you can pay off your debt faster and with less interest.
Another option is to take out a personal loan to consolidate your highest interest rate. You can probably find a personal loan for around 5% to 9% interest. If your credit card debt has an interest rate over 20%, you could potentially save 10% to 15% in interest.
To help you pay off your debt faster, you’ll want to increase your income as much as possible. Starting a new side hustle to make some extra money can be a good way to decrease loans quicker.
Reduce Your Retirement Risk
Before using your 401(k) to try to pay off your credit card debt, make sure that you are in a position to stay out of debt. It would not make sense financially to take out a loan to pay off your debt now to only get more debt later on. This starts with understanding why you got into debt in the first place an how to avoid it in the future.
The best option to pay off your credit card debt is to use a balance transfer or personal loan instead of your retirement account. If that is not possible, try to use a 401(k) loan instead of taking a distribution.
Always do your due diligence and calculate the exact costs when taking our a new loan. Understanding and accepting the risks is important to planning financially and being better prepared for the future.
