Should I Use My 401K to Pay Off Debt?
Dealing with excessive debt is never fun. Typically, we want to get rid of debt so quickly that most of us are willing to do whatever it takes, including using our 401k retirement savings. Then again, should you use some or all of it to pay off your debt? While part of you likely wants to be rid of your debt, the other half knows that saving for retirement is a very smart thing to do. So what should you do?
To find out what happens when you can’t afford to make your loan payments, click here.
What is a 401k Loan?
Before going any further, let’s make sure you understand what taking out a 401k loan actually means. This will vary by plan and employer, but certain 401k plans will allow contributors to borrow up to half of the balance of their retirement account for up to five years.
- Cheaper than other forms of high-interest loans
- No negative effect (or any impact at all) on your credit score
- A convenient way of getting rid of debt.
- Your retirement saving will be derailed
- High risk of penalties and tax consequences
Of course, before even attempting to take on one of these loans, be sure to find out if you do indeed qualify for one or not. If not, taking money out of your 401k will be very costly.
Should I Be Using My 401k To Pay Off Debt?
So if you have the option to pay off your credit card debt with your 401k savings, should you? Generally speaking, for a number of reasons the answer is no.
First of all, you will potentially lose quite a large chunk of money during the transaction. If you are a relatively young person (under 60), you will have to pay a 10% penalty, plus any income tax that is due on the withdrawal, unless you are approved for a 401k loan. This means you could lose a large portion of this money just by taking it out of your 401k. There is also a risk of other penalties, which can be costly. It is a risky move that doesn’t always pay off.
Also, if you remove money from your 401k, you are missing out on the potential gains of these funds in your retirement account. Time is the best way to grow money in your retirement accounts, so you are severely hurting your retirement by removing the money without giving it time to grow and mature over the years. It is simply a very short-term decision. In many cases, a few lifestyle changes and cutting back on costs and expenses are the best way to attack your debt.
Read this if you’d like to create a budget that works for your lifestyle.
Additionally, using a 401k to pay off debt doesn’t do anything to prevent you from incurring the debt again. While you may be able to pay off your debt this one time, what is to stop you from getting into debt trouble again in the future? The solution you go with shouldn’t only be one that gets you out of debt now, but one that helps you stay out of it.
When Is It a Good Idea to Cash Out a 401k To Pay Off Debt?
While the answer is normally never, there are certain situations in which it makes sense to use a 401k to pay off debt. One situation where it makes sense to borrow from your 401k is if you are getting close to a foreclosure or declaring bankruptcy. Both a foreclosure and a bankruptcy are huge, devastating things to go through and anything that you can do to avoid them should be done.
Looking for some professional advice? Seek out credit counseling in your area.
Also, if you are getting taken to court by creditors over missed or late payments, it can sometimes be a good plan to use part of your 401k money to avoid getting into legal troubles, which can end up being quite costly as well.
Of course, if you also have other retirement savings such as a beefed-up IRA or other investments, losing a little from your 401k isn’t the worst thing in the world, especially if it will help eliminate debt that you have been battling with for years. Basically, if you truly need the money from the 401k to save yourself or your credit from some major damage, it is okay to borrow from it, but don’t make it a habit, of course.
You can also try a debt management program.
Alternatives to Using 401k to Pay Off Debt
If you are dealing with a ton of debt issues, but don’t have enough or make enough to get yourself back on your feet, there are a variety of other things that you can do.
A debt settlement or a debt consolidation loan are both common debt relief solutions that could work for you.
- Debt settlement essentially means that you agree to settle with your creditors for less than the original amount, which can help you save money in the long term.
- Debt consolidation is about combining all of your debt into one affordable payment, while also likely getting a lower interest rate. Of course, no matter what decision you ultimately make, you should be sure to do look for some financial counseling to ensure you are able to avoid getting into debt trouble in the future.
Before trying, be sure to find out if debt consolidation damages your credit score.
Looking For Help With Your Debt?
If you’re currently struggling with debt and are thinking about a 401k loan to pay it off, we urge you to first consider other forms of debt relief. Rebound Finance can help match you with the right option for you and your unique needs.