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?