Whether you have student loans or credit card debt, cashing out your 401(k) to pay off debt can be tempting. You may even have a substantial amount saved, so why not use it to eliminate debt?
While the idea might make intuitive sense to you, you should carefully consider the possible effects of such a decision, as well as your alternative options, before moving forward. Here are the considerations to keep in mind.
Does Your 401(k) Plan Allow It?
You might not be able to access the funds in your 401(k) while you're still working. Depending on which features your employer selected when establishing your plan, withdrawals may not be available at all. Even if you're allowed to withdraw the funds, if you're under age 59 1/2, you'll have to pay a 10% early withdrawal fee unless certain exceptions apply. You might be able to access funds through hardship distributions or in-service distributions, but you must meet specific criteria to do so, as defined by the IRS.
What Are the Tax Consequences?
Withdrawing from your 401(k) plan can create tax consequences, which could potentially leave you with less money available than you might have expected. Here are a couple considerations to keep in mind.
Income Tax & Penalties
When you withdraw pretax funds from a retirement account, you often owe income tax on the amount you receive. Depending on the amount taken out, withdrawing funds may also put you into a higher tax bracket. Plus, as previously mentioned, if you're under the age of 59 1/2, you will owe an additional 10% early withdrawal penalty, unless you qualify for an exception.
You might not receive 100% of the funds available to you when you cash out. The IRS generally requires employers to withhold 20% of taxable amounts that are paid directly to you. For example, if you plan to withdraw $10,000 of pretax money, you'll only receive $8,000. That withholding is only an estimate, and you may owe additional taxes (or receive a refund) later. Consider discussing your situation with a tax professional before you make a decision.
When It Could Make Sense to Take Money Out of Your 401(k)
While withdrawing from your 401(k) to pay off debt could cause you to get off track when it comes to your retirement goals, it may still make sense in certain situations. Here are a couple examples.
Need for Income
When you need cash for an emergency, and you don't have an emergency fund, it may make sense to take funds from your retirement account. For example, if your car needs repairs so you can continue commuting for your job or you have an expensive health-related emergency that you can't cover, you might consider taking a distribution.
Debt With High Interest Rates
High interest rates can have a negative impact on your finances. If you're paying extremely high interest on debt, you might consider tapping retirement savings to quickly eliminate it. Then consider making a plan to prevent going back into debt.
What Are the Alternatives to Cashing Out Your 401(k)?
You've worked hard to save money for retirement, so before you take funds from your 401(k), consider evaluating several alternatives. Here are a handful to keep in mind.
Debt Consolidation or Refinancing
It may be possible to restructure your debt. If you refinance or consolidate debts, you may be able to obtain a lower monthly payment. With lower interest rates or an extended repayment period, you might find some relief. Before doing anything, consider weighing the pros and cons of getting a new loan to replace your existing debts.
Discuss payment options with your creditors. Some organizations may allow you to lower your monthly payment (based on your monthly income, for example). Some creditors might even allow you to pay back what you owe interest-free.
Negotiate a Lower Rate
A low interest rate can potentially result in a lower payment and help minimize the cost. Ask credit card issuers and other lenders how you can qualify for a lower rate. If you have a history of on-time payments, that might help you negotiate.
Instead of cashing out, you may want to consider taking a 401(k) loan. With a loan, you typically have access to $50,000 or 50% of your vested account balance, whichever is less. Eventually, you repay the loan over time. Borrowing may be less disruptive to your finances than cashing out, although loans can reduce the amount you earn if your investments perform well.
The Bottom Line
If you have a substantial balance, cashing out your 401(k) to pay off debt may seem appealing. But the dollars might not go as far as you expect after taxes, and you might not even have the option to cash out while you're still working. Consider weighing your options and exploring alternative strategies before you request a distribution. For more information, consider speaking with a tax advisor.