Should You Use Your 401(k) or Retirement to Pay Off Debt?

Paying interest on a credit card loan can be frustrating and expensive. In some cases, the desire to become debt-free is so great that you might be willing to do just about anything to get rid of the credit card debt hanging over your head – even take money out of your retirement account to pay off the debt.

Why It Looks Attractive

In a time of stock market volatility, you might have seen your retirement investment returns diminish – and even go negative – it might be tempting to put that money to better use by paying off debt and getting rid of the higher interest payments. You can also take out a loan on your 401(k) and pay back what you borrowed to avoid paying taxes on the money disbursed to pay off debt. When you borrow from your retirement plan, you are borrowing from yourself. So, you pay off your credit card debt, but you still need to repay your 401(k) loan. You make payments plus interest back into your account, so you are paying yourself the interest, rather than giving it to the credit card companies.

This seems like a great idea, especially since, if it is a loan from your retirement account, you won’t be charged the 10% penalty (this is on top of your tax rate) for withdrawing before reaching the age of 59-1/2, and you won’t have to report the money as income.

Why You Shouldn’t Do It

Of course, there are downsides to using retirement account money to pay off your credit card debt. First of all, if you withdraw the money outright, without using a loan, you will have to pay a penalty of 10% of the amount, if you aren’t 59-1/2. Plus, the withdrawal amount will be added to your income, and you will have to pay income tax on it. The additional income withdrawn from your retirement account and required to be reported may also bump you up into another tax bracket and also make income that is normally not taxable like Social Security income taxable.

Even if you go the loan route instead, there are definite downsides to using retirement money to pay off credit card debt. You will have to pay a loan fee and you will have missed opportunities. Without that money sitting in your retirement account, working for you, you won’t have as much later. Yes, you are putting the money back as you repay your loan, but for a time, the capital was missing from your account, and you missed out on compound interest. That will result in a smaller nest egg over time.

You also can’t discount the problems that can come with a retirement account loan if you are laid off. If you lose your job while you have a loan outstanding, most plans require that you repay the remainder of the balance within 60 days. If you default on your 401(k) loan, you won’t see a ding on your credit report, but your loan will be reported as a distribution, and you will then be subject to penalties and taxes.

In many cases, taking money out of your retirement account has the potential to cost a great deal. Consider the viability of putting together a debt reduction plan using the snowball method where you start paying down the lowest credit card balance first before you withdraw money from your retirement account. You can also use Intuit’s free loan calculator to help you figure out a plan. If you do decide to take the money from your account, make sure you repay it as quickly as you can, and try to avoid penalties and taxes.

Are There Any Ways to Avoid Early Withdrawal Penalties?

There are certain hardship cases where you will be allowed to withdraw from your retirement and avoid the additional 10% early withdrawal penalty if you withdraw before 59-½.  The following are some of the circumstances where you may avoid an early withdrawal penalty:

• Distributions due to terminal illness
• Total and permanent disability
• To purchase your first home, up to $10,000
• Qualified higher education expenses
• Distributions of up to $5,000 per child for qualified birth and adoption expenses
• Up to $22,000 if you sustain a loss due to a federally declared disaster where you live

Public safety employees like firemen who retire from service can avoid the additional 10% early withdrawal penalty after 50 as opposed to receiving a penalty for early withdrawal before 59-½.

Under the SECURE Act 2.0, beginning in 2024, you will be allowed to take an early emergency distribution from a pension-linked emergency account to cover immediate needs up to $1,000 once a year without an additional 10% penalty if your employer offers this type of account. Under the SECURE Act 2.0, starting in 2024, your employer may also match qualified student loan repayments you make.

Don’t worry about knowing these tax rules. No matter what moves you made last year, TurboTax will make them count on your taxes. Whether you want to do your taxes yourself or have a TurboTax expert file for you, we’ll make sure you get every dollar you deserve and your biggest possible refund – guaranteed.