Using Your 401(k) In Paying Debt

Written by True Tamplin, BSc, CEPF® | Reviewed by Editorial Team

Updated on January 04, 2023

What Is a 401(k) Account?

A 401(k) account is a retirement savings account that is sponsored by an employer.

Employees agree to contribute a percentage of their paychecks to the account which may either be done in pre-tax or post-tax payments.

There are two types of 401(k) accounts: traditional and Roth.

With a traditional 401(k) account, employee contributions are taken from gross income. This means that the employee's taxable income for the year is reduced by the amount of contribution. Hence, no taxes will be collected until the employee does a withdrawal from the account.

On the other hand, contributions made to a Roth 401(k) are deducted from the employee's post-tax income. Hence, no taxes will be collected when the employee makes a withdrawal from the account.

Rules in Withdrawing Funds From a 401(k) Account

Generally, withdrawals can be made from a 401(k) account given the plan owner meets any of the following conditions:

Reaching the Age of 59 1/2

If a withdrawal is done before this age, a 10% early withdrawal penalty will be collected.

Also, early withdrawals will be subject to income tax at the plan owner's regular income tax rate.

Plan Owner Becomes Disabled

If a plan owner becomes disabled, defined as rendering the plan owner incapable of self-sustaining employment with loss of income, then withdrawals may be allowed even if the plan owner has not reached 59 ½.

However, any withdrawal made will still incur the penalty and taxes on an early withdrawal.

Plan Owner Is Withdrawn From the Workforce

If a plan owner is terminated from an employer, then withdrawals will be allowed.

However, if the plan owner was employed full-time for at least 5 of the last 10 years by that company (or any company who provided the 401(k) account), then taxes and penalties on early withdrawal may be waived.

Note though that this rule does not apply to self-employed individuals.

Plan Owner Dies

If the plan owner dies, then the beneficiaries will be able to make a withdrawal from the account.

The beneficiary must provide a death certificate to the plan administrator in order to initiate the process.

Employer Terminates the Plan and Does Not Replace It With Another Plan

If an employer decides to terminate the 401(k) account and does not offer a replacement plan, then plan owners will be allowed to withdraw their funds.

Reason for Withdrawal Is Financial Hardship

What may count as financial hardship are cases when the employee has to pay for medical expenses for himself, for a spouse, or children; buys a house; pays school expenses; pays for property to avoid foreclosure or eviction; or pays for funeral expenses.

Things to Consider When Withdrawing From a 401(k) Account

If you are considering withdrawing funds from your 401(k) account in order to pay off some debts, here are some things to consider:

Lower Interest Rate

The interest rate from a borrowed 401(k) account will be lower than when you borrow from a bank.

Although there may be fees associated with the borrowing, they are still likely to be lesser compared to the early withdrawal fees.

Limits in Borrowing

You are allowed to borrow up to half of your vested account balance or $50,000, whichever is lower.

The same limit applies if you engage in multiple borrowings from the 401(k) account.

Short Repayment Term

The repayment term for a 401(k) loan is usually 5 years unless the loan is used for a house purchase which comes with a longer repayment term.

No Credit Check

When you borrow from your 401(k) account, you are not subjected to a credit check.

This may be beneficial if you have a low credit score.

Suspension of Contributions

Your employer has the option to temporarily suspend making contributions to the plan until repayment has been completed.

This means that you will lose the chance of growing your nest egg after borrowing from it.

Should I Withdraw From My 401(k) Account to Pay Debts?

Before you decide to withdraw from your 401(k) account, you should be aware of the benefits and drawbacks associated with it.

It is important to make a comprehensive comparison especially in terms of interest rate on the debt and penalties following the withdrawal. Should you opt for the 401(k) loan, make sure this is advantageous compared to the bank loan.

Also, it matters to have a good financial plan in place so that you can efficiently pay off the debts and simultaneously contribute to your retirement account.

In most cases, it is wiser to not withdraw from your 401(k). Instead, you must seek a more advantageous alternative such as a personal loan or credit card debt consolidation.

You should try to look for other options before resorting to the 401(k) account since these loans have penalties and risks associated with them.

This will go a long way in ensuring that you do not incur financial hardships later on due to these withdrawals.

Final Thoughts

Using your 401(k) to pay off debts has its own advantages and disadvantages. Before you take any action, be sure to weigh these pros and cons carefully so you can make the best decision for your financial situation.

Always take into consideration the interest rates, penalties, taxes, and other associated costs before making a decision. If you are unsure what to do, it is best to speak with a financial advisor for more guidance.

 

FAQs

What are other options I can take to pay off debts without using my 401(k) funds?

Some other options you can take are personal loans, credit card debt consolidation, and home equity loans. However, each of these options has its own risks and benefits so be sure to do your research before deciding on which one is best for you.

Can I withdraw money from my 401(k) to pay for emergencies?

401(k) funds can be used for emergencies but it's important to note that there are penalties associated with early withdrawals. It's usually best to try and find other ways to come up with the money needed for emergencies instead of withdrawing from your retirement savings.

Why is there a lower interest rate when borrowing from a 401(k) compared to a bank?

The interest rate for a 401(k) loan is lower because the funds are coming from the account itself. When you borrow from a bank, you are borrowing money that has been set aside to be used for loans. This means that the bank has to charge a higher interest rate to make a profit. 401(k) funds are not as readily available as money from a bank so this is why the interest rate is lower.

Can my employer suspend contributions to my 401(k) if I take out a loan?

Yes, your employer can suspend contributions to your 401(k) plan if you take out a loan. This means that you will miss out on the opportunity to grow your nest egg while you are repaying the loan.

How can a financial advisor help me in making the right decision?

Your financial advisor will help you weigh the pros and cons to determine if a 401(k) loan is best for you. They can also guide the process so that you know what to expect.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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