Should you use your 401(k) money to pay off your debt?

401K, IRA, Stocks

Asked by Chris at the TurboTax Facebook site:

I’d like to see an article about the tax and long-term financial implications of using 401k loans or early withdrawals to pay off debts (credit cards, student loans, mortgage, etc.). Does it make sense to be paying a higher interest rate on debt than I’m making in my retirement investments?

Deciding to raid one’s retirement plan for debt repayment is not a decision to be taken lightly. I’m glad you took the time to ask for help before taking money from your future.

A 401(k) plan is a retirement plan and the government gives us some pretty big incentives to use it exclusively as one. Consequently, my bias is to avoid taking money from a 401(k) plan at all costs. Of the examples you mention, only the existence of significant high-interest credit cards would cause me to consider making an exception. (Student loans and home mortgages are “good debt” and are typically at a low cost. The negatives, discussed below, of pulling money out of your 401(k) greatly exceed the benefits of more aggressively reducing relatively low-cost “good debt.”)

On the other hand, credit card debt can be extremely expensive. For example, if you’re paying 20% or more APY on a sizable credit card balance, it might take you a very long time to pay back your debt. As such, if you could borrow from your 401(k) plan and pay off all (or nearly all) of your credit card debt, I’d consider it. Yet even in such a situation, it’s still not a no-brainer to do so to borrow from your 401(k) plan. Here’s why:

A 401(k) loan is risky. Should you terminate employment for any reason (e.g., lay-off, spouse gets a job in a different city, you get really irritated at your boss one day, etc.) your loan is typically due, in full, within 60 days. When you can’t pay it back (and you won’t be able to – if you could, you would have paid it back already), the entire outstanding loan is considered a distribution. As such, you’ll be subject to income taxes, plus a 10% early distribution penalty if you’re under 59 ½. This potentially large sum will be due no later than the following April 15. Will you have the money available? Unlikely, making matters even worse.

An outright distribution from a 401(k) plan is no better. After all, you permanently reduce the amount available to you at retirement.

Furthermore, keep in mind your retirement plan money is typically unavailable to debt collectors, even in bankruptcy. While I believe people should pay what they owe, one needs to be wise to all the angles.

Taking money from your 401(k) plan should be a last resort and, in my mind, done only a very specific situation: as a loan to immediately and aggressively attack high-interest credit card debt by a person with a good deal of job security who is willing to make the significant commitment necessary to ensure the debt does not recur once more credit is available. Otherwise, steer clear and pay off your debt the old fashioned way – by spending less than you earn and using the difference to pay down debt.

What do you think? Have you taken a 401(k) loan or distribution? Glad you did or still paying for it?

Comments (23) Leave your comment

  1. I guess I look at this differently – everyone complains that the taxes are horrible, but you would have paid them if you didnt contribute, and you will pay them when you withdraw anyway regardless of age. The only time that you could screw yourself here is if the withdraw bumps you into another tax bracket.

    So really all there is to discuss here is the 10% early withdraw penalty. If that is worth the piece of mind to you to get out of debt I say GO FOR IT.

    All these returns of 8-12% a year have not been happening for most since 2007 – and inflation is gobbling up any gains below that you are getting.

    I hesitate to listen to the financial advisors as they have a vested interest in you staying.

    The real keys here are this: does/did your employer match contributions? and are you a conscientious enough person to save/invest elsewhere?

    If you are/ were matched dollar for dollar – put that much in at least – even if you want to take it out EVERY year – you will still come out ahead (based on your tax bracket)

    If you have ANY debt that is drawing interest above 5% or so that you cannot cashflow until gone within a few years – pay it off.

    The investment and retirement planning that we are being fed by these fast food investment planners is not accurate – they sell you what they are taught to sell you – THINK FOR YOURSELF

  2. I recently got married. I took out a loan on my 401k to pay $10,000 for the wedding, reception, etc. I “paid myself back” at 4% interest for a few months while we planned the wedding. Using the wedding gifts and funds collected from the guests, I then immediately paid back the loan. It worked out great!

  3. I do agree, Until Debt… If people aren’t on the same page, the battle is over before it starts. It can indeed be tough, but it is well worth it!

    Thanks for this post.

  4. I agree with you 100%. However, Many people lost job during the recession and ended up breaking 401(k),just to keep up with mortgage and bills, and to supply daily bread onto the dinner table to feed their family and children. What would you do if you are in this situation when your last cash is all dried out and no other income source is to be seen?

  5. Kikster, no offense, but you’re living under a rock if you think retirement funds aren’t up for grabs during a divorce. That money is NOT yours and yours alone. I know the hard way. That being said, I strongly doubt a judge would decide how debt would be settled (i.e., via retirement funds). He’s only going to decide who gets what assets and who gets what debt.

  6. Hi Kevin,

    If I were you I would pay a little visit to my HR department and get some additional clarification. My experience as an HR professional is that your spouse does have access to your 401K and if you should divorce you will have to give up 1/2, but sometimes it does depend on the laws of your state. So don’t be fooled :-)

  7. kevin karstetter – I’m pretty sure that a spouse can NOT touch ANY of your retirement in a divorce. That money is considered yours and yours alone! During a bankruptcy you can’t even be forced to use your retirement to pay off the debt.

  8. My husband changed jobs in early 2008 and needed to do something with his 401k. I suggested rolling it into a bank cd until he was at his new job long enough to start a 401k. He chose to cash it out to pay for some home repairs. BAD IDEA. The penalty for cashing it out early was very bad. And even worse we were taxed on it next year when we filed. We ended up with almost half it’s value. Before doing anything, ask a tax consultant what you will be up against.

  9. It is no one’s business how people use their 401K’s. We used ours to pay off some debt and it helped us alot. The banks were not willing to help and if they were we could not afford the intersest rate on any loan. Our money goes right back where we took it out and we watch it close and would do it again. Americans have to look arter themselves.

  10. Laid off-We had to take the 401(k) payoff or lose our house. Three months of emergency fund helped the first three months but not the six months after that. We of course were penalized and had to pay tax on it, but we had no recourse. We could not sell our house for what we paid for it. Now, we have sold our house and have a new job and are steadily contributing to a TSP and IRA’s and have six months of emergency fund. We will never catch up before retirement, but we are doing the best we can.

  11. I was forced to move from my prior location due to the crime rate escalating. When the drug addict/dealer moved in next door, it was TIME TO GO… I had limited funds and thought it impossible to buy a house.

    If it was not for my 401K, I would not have been able to purchase an affordable home.

    I bought a house in another city and better neighborhood. What price do you put on peace of mind and safety?

  12. I needed some important home repairs or my homeowners insurance was going to cancel me. The only choice I had, after trying to get other loans for over a year, was a loan from my 401(k). It’s been almost one year and it will be paid in four more. Thankful that I had that option.

  13. As a single woman living in NJ, I used my money from my 401K to pay off debt and get better footing. I’m alot better off but still not 100%. I also took care of people for a number of years who were worse off then me. If anyone wants to judge how I paid off my debt, let them walk and 1/8 of a mile in my shoes.

  14. I am a single mother of two, living on one salary and struggling to meet month end. I own a house and I have 7 more years to pay it. If I loose my job, I think I will take my 401K to pay my mortgage. I will not loose my house after so much sacrifice.

  15. We have medical expenses that were draining our income and costing us $500.00 a month more than our monthly income. We survived for awhile by selling possessions on ebay and a few odd jobs. Eventually we were in debt $25,000.00 with no relief in sight. We paid our debt off by borrowing against our house (which had been paid off in 1988). However, the medical expenses kept coming because I am without insurance due to pre-existing conditions…even though there are now supposed to be insurance options for someone like me, I haven’t found any yet. Finally, I am doing better and we can handle the monthly expenses, but we couldn’t pay our debt. We cashed in some of our retirement to get on our feet…and we are glad we did. Eventually, I should be well enough to return to work and rebuild part of our retirement…but not all that we lost. (We do not have to pay taxes on the money we took out as there are exceptions for medical expenses.) Of course, we don’t know what the future holds, but so far we are very happy to have our heads above water and to be able to live within our means again. Having our home free and clear again is great too.

  16. Divorce..Can my spouse get the courts to “make me” draw money from my 401K to settle our economic issues. I have approx 100K in the account and she wants half…we were only married 4 years. I no longer work for the company (TEXTRON) but want to let it ride till I reach retirement in about 10yrs.

  17. You hit all the high points here. Well addressed. I’d avoid touching the 401(k) if I could. It’s unfortunate that the high card rates create a spiral many people can’t get out of.

    At 4%, a 5 year loan of $10,000 would require a $184 monthly payment. At a 20% rate on a charge card, that same payment would take nearly 12 years to pay off the same $10,000.

    Worse case, if one loses their job, pull the cash back off a card. That avenue isn’t cheap, but a savings of 16% per year would negate the fee to do so.

    1. Pay off the debt first. Interest rates on savings are pcihettaally low. In the long run, you will save more money by paying off the debt and not spending it on interest fees. One way to get your debt under control is to focus on one card and pay it off. Then once it is paid off, take that money and increase another card’s payment by that amount until it is paid off. By paying off your debt, it will increase your credit rating and in the future you will get better interests rates on other loans, such as car and house. That can save you hundreds a month.References :

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