When Does It Make Sense To Use A 401k To Pay Off Your Debt

Use a 401k to Pay Your Debt

Are you planning to pay off your debt using your 401k retirement savings? Paying off debt using your 401(K) savings can make sense in some cases. But you need to remember that you are endangering your retirement savings. So think carefully before you tap in to your 401K savings to pay off your debt. If you consider this option, first you should compare the interest rate on your debt amount with the tax penalties you would have to face. Before you drain your entire 401k retirement savings, you need to know if you are eligible to withdraw funds.

Who is Eligible to Withdraw Money from a 401(k)?

According to IRS guidelines, you are eligible to withdraw money from your 401(K) plan if:

  • Your age is 59 ½ or above
  • You die or become disabled or are withdrawn from the workplace
  • The employer terminates your 401(K) plan and doesn’t replace it with another saving plan
  • The 401(K) distribution is related to financial hardships such as medical need, to pay tuition or educational fees, funeral expenses, avoid foreclosure or eviction, etc.

401(k) and Possible Penalties

Withdrawing money from your 401(k) plan comes at a cost, which varies depending on your age and how you take the funds. If you’re under age 59 ½ and make a withdrawal from your 401(K), you will have to pay a 10% penalty for early withdrawal of your funds, plus income taxes. If you’re at least 59 ½, you will not be charged with the early-withdrawal penalty but will owe regular income taxes. Tapping in to a 401(K) to pay off your debt is a reasonable choice if your debt is under $50,000, because you cannot withdraw an amount more than $50,000 from your 401(K) savings account. With a 401(K) loan you get the money to pay off your debt with a low-interest rate.

Experts Recommendation

Financial experts recommend that if you are earning and your retirement age is in the near future, eliminating debt before saving for retirement is always a better option. However, if you are in your retirement age, then you should look for different funding sources because withdrawing money from your 401(K) savings may drain your entire plan.

Reasons when it makes sense to turn to your 401(k) to pay off debt before retirement.

  1. For buying a home: If buying a home is your need and you don’t have a chunk of funds, then you should look for a 401(K) loan to pay the down payment.
  2. You encounter an emergency: If you faced a costly medical emergency or another urgent situation that might put you into new or greater debt, 401(k) funds could save you from that.
  3. To avoid bankruptcy: Mostly, it is not considered an excellent option to use your 401(k) to avoid bankruptcy, given that U.S. bankruptcy courts also shield retirement accounts. But if you want to go this route for professional or personal reasons, you can opt for this option. Before making this decision, it’s worth consulting with your financial professional or lawyer.