You have debt. But you’ve also got a stash of cash in your 401(k). If you’re feeling overwhelmed by high-interest credit card balances, a student loan, and/or an auto loan, you might think taking money out of your 401(k) is a good way to pay down that debt and get it under control But is withdrawing money from your 401(k) to pay off debt a good idea? How would you go about doing it — and then paying it back?
Related: How to make changes to your 401(k) contributions
What Are Some Options for Taking Money out of a 401(k)?
There are two basic options for taking money out of a 401(k): withdrawals and loans:
1. 401(k) Withdrawal
A 401(k) withdrawal removes money from your account permanently. You don’t pay the money back, but you can typically expect to pay taxes on the amount you withdraw. Depending on your age, you may have to pay an early withdrawal penalty as well.
2. 401(k) Loan
A loan lets you borrow money from your 401(k) account and then pay it back to yourself over time. You’ll pay interest, but the interest and payments you make will go back into your retirement account.
There are pros and cons for each of these options. And the rules can vary depending on your age and what your employer’s plan allows. Here are some things to consider.
What Are the Rules for 401(k) Withdrawal?
Tax-deferred retirement accounts like 401(k)s, 403(b)s, and others were designed to encourage workers to save for retirement, so the rules aren’t super friendly for those who want to make a withdrawal before age 59½. But depending on your financial situation, you may be able to request what the IRS calls a hardship distribution.
Employer retirement plans aren’t required to provide hardship distribution options to employees, but many do, so it may be worth checking with your HR department or plan administrator for details on what your plan allows.
According to the IRS, to qualify as a hardship, a 401(k) distribution must be made because of an “immediate and heavy financial need,” and the amount must be only what is necessary to satisfy this financial need. Expenses the IRS will automatically accept include:
- Certain medical costs.
- Costs related to buying a principal residence.
- Tuition and related educational fees and expenses.
- Payments necessary to avoid eviction or foreclosure.
- Burial or funeral expenses.
- Certain expenses to repair casualty losses to a principal residence (such as losses from a fire, earthquake or flood).
You still may not qualify for a hardship withdrawal, however, if you have other assets you could draw on or some kind of insurance that will cover your needs. And your employer may require documentation to back up your request.
Recommended: How does a 401(k) hardship withdrawal work?
You probably noticed that credit card and auto loan payments aren’t included on the IRS list. And even the tuition expense requirements can be a little tricky. You can ask for a hardship distribution to pay for tuition, related educational fees, and room and board expenses “for up to the next 12 months of post-secondary education” for yourself, your spouse, your children or your dependents. But you can’t expect to use a hardship distribution to repay a student loan from when you already attended college.
Are 401(k) Withdrawals Subject to Taxes and Penalties?
Even if you can qualify for a hardship distribution, it’s a good idea to plan to pay taxes on the distribution (which is generally treated as ordinary income). And, unless you meet specific criteria to qualify for a waiver, you’ll also pay a 10% early withdrawal penalty if you’re younger than 59½.
So, let’s say you’re 33 years old, and you have enough in your 401(k) to withdraw the $20,000 you need. Right off the top, unless you qualify for a waiver, you can expect to pay a $2,000 early withdrawal penalty. Then, when you file your income tax return, that 401(k) distribution will most likely be counted as ordinary income, so it will cost you even more. And if that added income bumps you into another tax bracket, you could end up paying even more.
But taxes and penalties aren’t the only costs to consider when you’re deciding whether to go the distribution route. Since compound interest creates the potential for your initial investment to grow significantly over time, every dollar you take out now could mean several dollars less in retirement. Essentially, withdrawing from your 401(k) now is like borrowing money from your future self because you’re losing long-term growth.
What Are the Costs Associated With 401(k) Loans?
You may be able to avoid paying an early withdrawal penalty and taxes if you borrow from your 401(k) instead of taking the money as a distribution. But 401(k) loans have their own set of rules and costs, so you should be sure you know what you’re getting into.
There are some appealing advantages to borrowing from a 401(k). For starters, if your plan offers loans (not all do), you might qualify based only on your participation in the plan. There won’t be a credit check or any impact to your credit score — even if you miss a payment. And borrowers generally have five years to pay back a 401(k) loan.
Another plus: though you’ll have to pay interest (usually one or two points above the prime rate), the interest will go back into your own 401(k) account — not to a lender as it would with a typical loan. You may have to pay an application fee and/or maintenance fee, however, which will reduce your account balance.
Of course, a potentially more impactful cost to consider is how borrowing a large sum from your 401(k) now could affect your lifestyle in retirement. Even though your outstanding balance will be earning interest, you’ll be the one paying that interest. Until you pay the money back, you’ll lose out on any market gains you might have had — and you’ll miss out on increasing your savings with the power of compound interest. If you reduce your 401(k) contributions while you’re making loan payments, you’ll further diminish your account’s potential growth.
Another risk to consider is that you might decide to leave your job before the loan is repaid. According to IRS regulations, you must repay whatever you still owe on your 401(k) loan within 60 days of leaving your employer. If you fail to pay off the outstanding balance in that time, it will be considered a distribution from your plan. And when tax time rolls around, you’ll have to include that amount on your federal and state tax returns, where, typically, it will be considered ordinary income.
If you’re under the age of 59-and-a-half and the loan balance becomes a distribution, you may also have to pay a 10% early withdrawal penalty. There may be similar consequences if you default on a 401(k) loan.
What Are Some Ways of Minimizing Risks to Your Retirement?
If you decide using a 401(k) to pay off debt is your best (or only) option, here are a few things that could help you lower your financial risk:
- Not using your high-interest credit cards once you use your 401(k) to pay them off. If you continue to use your credit cards, and then have credit cards and the 401(k) loan payments to make every month, you could end up in even more financial trouble.
- Continuing to make contributions to your 401(k) while you’re repaying the loan — at least enough to get your employer’s match.
- Not overborrowing. Creating a budget could help you determine how much you can comfortably pay each quarter while staying on track with other goals. And try to stick to taking only the amount you really need to dump your debt and no more.
Why Do People Use Their 401(k) to Pay Down Debt?
Although there are significant costs involved in taking money out of a 401(k) to pay debt, many people still do it. It can seem like a good option if you have high-interest debt like credit card debt and you have to face those bills every month. If you have lower interest debt like student loans, personal loans, auto loans, or a home equity line of credit (HELOC), then the early withdrawal penalty and other consequences may be a deterrent.
But if you’re paying high interest on your current debt, or if you have debt payments due and no way to cover them, using your 401(k) might seem better than the risks of missing payments on those bills. Late payments can rack up fees, interest and can ding your credit score. And if you default on a debt, that can have even more dire consequences, potentially including court actions and wage garnishment — depending on the type of debt and the creditor or lender. You can’t exactly wait it out and count on winning the lottery or inheriting money from some long-lost relative.
If your credit score ends up damaged due to late payments, that, too, could have a huge impact on your finances. Having a low credit score can make it more difficult to get loans in the future. You might have to pay a higher interest rate or there might be limits on how much you can borrow.
Given the dire consequences of doing nothing, using your 401(k) to pay off debt might seem like an attractive choice. But before you contact your HR department or plan administrator to request a loan or withdrawal, you may want to take time to look at some other options that could help you repay your debts.
What Are Some Alternatives to Taking Money Out of Your 401(k)?
When it comes to paying down debt, your 401(k) isn’t the first or only place you can look for relief. There are some solid alternatives.
For example, refinancing your debt might be an option. When it comes to things like refinancing your student loans or auto loans, you might be able to get a lower interest rate than you’re currently paying.
This may be especially true if your credit score or income has improved since you first took out your loan. If you took out educational loans when you were still a student, for example, you’re likely making more money now and might have built up a credit history that could make you eligible for a better deal.
If you have federal student loans and are still working toward that dream job (and salary), you could look into income-driven repayment plans that limit the amount that you pay each month to a certain percentage of your monthly discretionary income — which could help keep your monthly payments more manageable.
Many of these plans will also forgive any remaining balance on your federal student loans after 20 to 25 years of qualifying, on-time payments — something that you won’t be able to take advantage of if you pay off your loans with your 401(k).
If you still need help, you could look into whether you qualify to have your federal student loans put into forbearance or deferment (although you’ll want to consider these programs carefully, as you may still be responsible for any interest that accrues).
If you have credit card debt or other high-interest debt, you could look into a credit card consolidation loan. Debt consolidation loans are loans designed to pay off your current loans or credit cards, ideally at a lower interest rate or with more favorable terms. You can get these loans from a bank, credit union or online lender, often by filling out a quick form and sending a few scanned documents. But it’s important to remember that this is still taking on debt, even if it’s debt with different terms.
One critical thing to remember when using a personal loan to refinance or consolidate debt is that you may have the option to extend the length of your loan, which may reduce your monthly payments and free up some near-term cash flow. While extending your loan term means you’ll likely pay more in interest over the life of your loan, it might be a worthwhile move to ensure you can cover your debt payments.
The Takeaway
It may not have ever crossed your mind when you opened your 401(k), that you’d use it for anything other than retirement. And though it may be tempting to tap it now, especially if you’re facing a daunting amount of expensive debt, that’s a decision with both short- and long-term consequences. Before you use your 401(k) to pay off debt, you may want to consider other available alternatives.
Learn more:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
SoFi Loan Products
SoFi loans are originated by SoFi Lending Corp. or an affiliate (dba SoFi), a lender licensed by the Department of Financial Protection and Innovation under the California Financing Law, license # 6054612; NMLS # 1121636. For additional product-specific legal and licensing information, see SoFi.com/legal.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
SoFi Student Loan Refinance
IF YOU ARE LOOKING TO REFINANCE FEDERAL STUDENT LOANS PLEASE BE AWARE OF RECENT LEGISLATIVE CHANGES THAT HAVE SUSPENDED ALL FEDERAL STUDENT LOAN PAYMENTS AND WAIVED INTEREST CHARGES ON FEDERALLY HELD LOANS UNTIL THE END OF JANUARY 2022 DUE TO COVID-19. PLEASE CAREFULLY CONSIDER THESE CHANGES BEFORE REFINANCING FEDERALLY HELD LOANS WITH SOFI, SINCE IN DOING SO YOU WILL NO LONGER QUALIFY FOR THE FEDERAL LOAN PAYMENT SUSPENSION, INTEREST WAIVER, OR ANY OTHER CURRENT OR FUTURE BENEFITS APPLICABLE TO FEDERAL LOANS. CLICK HERE FOR MORE INFORMATION.
Notice: SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income-Driven Repayment plans, including Income-Contingent Repayment or PAYE. SoFi always recommends that you consult a qualified financial advisor to discuss what is best for your unique situation.
Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website.
SoFi Invest
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC. SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
More from MediaFeed:
9 smart ways to pay off student loans
No one ever wants to talk about the unglamorous work that goes on behind the scenes, but it’s the unspoken progress that makes or breaks every successful business owner, athlete, or creative person. It is helpful to have this mindset and to think about student loan repayment like any other big feat worth accomplishing.
It begins in knowing that paying down student loans in a way that is financially smart and effective takes time and effort, most of which lies in the preparation — the proper planning, budgeting and education will make tackling your student loans during the next decade or more so much easier.
While there is no one single smartest way to pay off student loans, there are steps that you can take that will put you in the best position to pay off your student loans on a timeline and with terms that work best for you. In addition to understanding your student loans, your goal should be to build an overall financial plan that includes your loans.
Related: Why your student loan balance never seems to decrease
9 ways to pay off student loans
If you want to understand how to repay student loans in the smartest and most financially responsible way possible, here are nine steps to implement in your loan repayment plan.
jacoblund / istockphoto
Keeping track of all of your student loans and other sources of debt can be tricky, especially if you are a recent graduate. Your first step should be to organize them on a list. On your list should include the loan service provider (the bank, federal government, or private lender), amount of the loan, monthly payment, interest rate and when the loan will be paid off in full.
If you aren’t sure what your monthly payments on your student loans will be, you can use our student loan calculator. This calculator estimates how much you could be paying each month on your student loans.
If you have credit card debt or other personal loans, include these on your list. With all of your sources of debt, mark on a calendar the date that the monthly payments are due.
While you always need to make the monthly minimum payments on all debts (unless your student loans are within their grace period or are in forbearance), listing them out allows you to identify which debts to pay off first. If you have high interest credit cards adding up each month, a credit card consolidation loan may be a great option to look at.
Once your credit cards are paid off, you’ll want to think about whether your goal is to pay your loans off quickly, or to simply make the monthly payments until the loans are done. The former is a good way to save on interest over time.
Some folks do prefer to pay only the minimum monthly amount on their student loans so that they can save and invest while they pay down their student loans.
If the interest rates on your student loans are low, this may be a good reason to start investing with your extra funds, in order to take advantage of compound returns. If the interest on your loans is higher than you could reasonably expect to make investing, it might make more sense to pay off your loans first. Which option is right for you is a completely personal decision.
DepositPhotos.com
No matter who you are, learning how to budget your money should be on the top of your financial to-do list. It takes time and effort to develop a budgeting system that works for you, but it is doable, and totally worth it. To get started, track your monthly cash inflows and outflows for two months.
Total up how much money you spent in each category, including debt payments like student loans. Once you have a general idea of what you’re spending in each category, you can begin to build a budget framework. For example, if you spend $260 on groceries one month and $300 the next, you can now set yourself a realistic grocery budget. Leave room for annual, bi-annual and quarterly expenses, as well as incidentals.
With a budget that is built to include student loan payments, you’ll be more equipped to make all of your payments on-time and know how much is available to spend on other needs and wants. Also, understanding exactly how you’re spending allows you to identify the areas where you’re overspending.
For example, a close look at your budget could reveal that you’re spending more than you realized on dining out, subscriptions, clothing, or even rent — and gives you the power to make a change. And by saving money in other categories, you’ll free up money to apply to your financial goals.
DepositPhotos.com
Hopefully, your student loans are already set up to be automatically deducted from your bank account. (This is a good strategy for all your monthly bills.) If they aren’t, contact your student loan service provider to set it up. This way, you’ll never miss a payment because you forgot or are somewhere where you can’t access the internet.
Remember, every time you miss or are late on a payment, it negatively impacts your credit score. Bad credit could preclude you from opportunities in the future, such as being able to refinance your loan to a lower interest rate. Take every extra precaution to make sure your loans get paid on time.
As an added bonus, some service providers offer a discount, usually.25%, if you arrange to pay by automatic payments. When you sign up, be sure to ask if such a discount is available.
Youngoldman / istockphoto
Most student loans allow you to pay more than the minimum monthly payment, and doing so can be a great strategy if your goal is to pay back your loan faster than the stated term. In addition to a faster payoff, you can save on interest over the life of the loan. Even small amounts make a difference. One drawback is that some providers have prepayment penalties. When you contact you student loan service provider, be sure to ask if they charge such fees.
To do this, call your loan service provider to adjust your automated monthly payment to a higher amount, and clarify that you want that money dedicated to the principal of the loan. Make sure, after the next month’s payment, that the money was indeed put towards the loan’s principal.
Looking for more advice on paying down your student loans? SoFi’s student loan help center offers tips, guides and resources on all things student loans.
Deposit Photos
Increasing your monthly payment isn’t the only way to put a dent in your loans; at any point, you are allowed to make a lump sum payment towards the principal of your loan. This is a great way to speed up the student loan repayment process without having to commit to paying more each and every month.
You may have more opportunities to do this than you think: Utilize your tax refund, holiday money, birthday money, work bonuses or inheritance money. Additionally, putting income from a side hustle or other passive income towards student loans could be a financially rewarding move over the long-term.
Depositphotos
Most federal student loans come with a standard, ten-year repayment plan. With federal loans, there are other options for repayment plans with lower monthly payments, calculated using your income. These plans lower your monthly payments by extending the length of your loan, usually from ten years to twenty or more years.
When you choose one of these options, it is important to know that even though your monthly payments are lower, you can end up paying more in interest over time. Therefore, it’s not a great choice if you want to pay off your loans quickly or pay as little in interest as possible, but it is available to those who are having trouble making their monthly payments.
If you are planning to utilize the Public Student Loan Forgiveness program for your federal loans, you will need to select one of the income-dependent repayment programs.
insta_photos/istockphoto
When you refinance a loan or multiple loans, a lender pays off your current loan(s) and provides you with a new loan, ideally at a lower rate. A lower interest rate could mean savings over the life of your loan.
Though refinancing might not be the right option for everyone, it’s a strategy that every student loan holder should, in the very least, research and consider. Also, understand that while refinancing can consolidate multiple loans, federal loan consolidation is a different process. With federal loan consolidation, the government bundles your loans together into one, using a weighted average of the interest rates.
If you are able to refinance to a lower rate, you will want to ask yourself whether the purpose is to lower your monthly payment but keep the same term, freeing up some money in your monthly budget, or to keep your monthly payment the same (or higher) and to shorten your term so that you can pay off your student debt faster.
Exploring refinancing with a private lender usually doesn’t take a lot of time and it doesn’t cost you anything.
Drazen Zigic/istockphoto
With all raises, you can use the extra income towards your financial goals. This could mean increasing the monthly amount you pay towards your loans, making the occasional lump sum payment towards the loan with the extra windfall, and/or saving and investing money for your other long-term financial goals.
How much money you earn is an important factor contributing to your financial stability and ability to pay down your student debt. While budgeting is important, so is knowing your worth and asking for more when you deserve it. If you haven’t already, start keeping track of your successes now so that at your next compensation conversation, you’re loaded with concrete data on why you deserve a bump.
fizkes / istockphoto
Although not yet as widespread as retirement or healthcare benefits, more employers are offering student loan repayment help as a benefit to attract and retain employees.
Depending on your personal situation, student loan repayment help could be as important than a raise or other benefits. Whenever you’re comparing job offers, it’s critical to understand and compare benefits packages, because although they’re not flashy like a big salary or company equity, benefits can be just as valuable.
If you’re looking for a new job, include student loan repayment help in your search. While it shouldn’t be your only consideration, it’s great to have an idea of what you’re looking for in an employer.
Learn more:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
Notice: SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income Based Repayment or Income Contingent Repayment or PAYE. SoFi always recommends that you consult a qualified financial advisor to discuss what is best for your unique situation.
Depositphotos
Featured Image Credit: designer491 / istockphoto.
