Here are some important questions to consider before making a 401(k) withdrawal to pay off debt.
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What is a 401(k) withdrawal?
Withdrawing a portion of your 401(k)—or cashing it out altogether—means you’re taking money out of your account with no commitment to pay it back. This may seem like an easy way to tackle your debt, but be careful. Cashing out your 401(k) might leave you less money for retirement. In addition, there may be big costs involved, specifically higher taxes and early withdrawal penalties.
Will I be penalized if I cash out my 401(k)?
Whether you are penalized for withdrawing from your 401(k) depends on your age and your circumstances. Taking a withdrawal before age 59½ may result in a 10% early-withdrawal penalty.1 It may also increase your tax burden for the year.2
Traditional 401(k) withdrawals are usually taxed at your current tax rate. Depending on the type of contributions made, this may cancel out some of the tax benefits you previously enjoyed.
If you are facing medical, funeral, tuition or other education-related expenses, you may qualify for a 401(k) hardship withdrawal based on an “immediate and heavy financial need.”3 If eligible, you may avoid a penalty. Be sure to check your plan terms carefully to learn about the penalties and costs you might face. And it is always important to check with an accountant or tax specialist to learn more before making any decisions of this kind.
What is the difference between borrowing and withdrawing from my 401(k)?
If you do decide to use your 401(k) to help pay your debt or expenses, withdrawing your money is not the only option. You might also consider borrowing from it. Whether you are thinking of withdrawing or borrowing, the first step is to check with your plan administrator to learn about your options.
Then, compare them. Borrowing from your 401(k) generally requires repayment within a set payback period (typically five years), while withdrawing means taking money out of your 401(k), or cashing it out altogether, with no intention of paying it back.4
You might believe that borrowing or withdrawing from your 401(k) is a fast way to solve your debt problem. But keep in mind that there may be significant costs involved. You will especially want to be prepared for possible withdrawal penalties.
What are the long-term effects of using a 401(k) to pay off debt?
Using your 401(k) for debt may seem tempting, but it might hinder your long-term investment growth. After all, the longer your money is in your account, the more exposure you have to the markets and their potential gains and losses.
What are some other ways to pay down my debt?
Because of the possible impact of cashing out your 401(k), you might want to consider other ways to both save and pay down debt. Here are some strategies:
1. Create a budget
If you don’t already have one, now is a good time to start exploring how to create a budget. When you put it on paper, it may help you see exactly how much money you have coming in and how much is going out, which should include paying down debt as well as saving.
If this is your first time building a budget, consider adopting the 50/30/20 rule, which suggests that 50% goes to essentials, 30% to wants, and 20% to savings.
2. Choose a budget strategy for tackling debt
One key to a good budget starts with lowering your debt while still allowing for the occasional splurge. There are two ways you might consider to help make this happen: The debt snowball or debt avalanche method. A “snowball” strategy means that you pay your smallest debt first while making minimum payments on the others. This is great if you enjoy the satisfaction of crossing things off your list.
A second strategy is an “avalanche.” With this one, you make minimum payments on all debts but use any additional funds to make larger payments on the debt with the highest interest rate. Erasing those debts first might help save more in the long run because you’re eliminating your larger interest payments.
3. Temporarily suspend 401(k) contributions
Another alternative to using your 401(k) to pay off debt is to stop contributions temporarily and use that cash to pay down your debt.
Keep in mind that if your employer matches a percentage of your personal 401(k) contributions, stopping your contributions means missing out on those matching funds. Try to contribute at least as much as your company matches so you don’t lose out on “free money.” If you choose this method, remember to restart contributions when your financial situation allows.
4. Explore a debt consolidation loan to lower your monthly payments
Sometimes the sheer number of outstanding accounts is the most overwhelming thing about debt, especially if they have different repayment terms and the bills come due at various times during the month.
With a personal loan for debt consolidation you could combine your various higher-interest debts into one monthly payment with a fixed interest rate. Plus, a loan for debt consolidation may give you a light at the end of the tunnel: your one set regular monthly payment schedule lets you circle an end date on the calendar. That way, you will be able to see when the loan will be paid off. Personal loans come with a variety of repayment schedules, letting you choose the amount you can comfortably pay each month.
How can I move towards a debt-free future?
Tapping your 401(k) may appear to offer some immediate advantages, but take the time to carefully review the possibilities. You might be pleasantly surprised to know that it is possible to keep saving while paying down debt—without touching your 401(k).
A debt-free future may be closer than you think. Find out how much you may be able to save on interest with a debt consolidation loan from Discover®.
