Should you tap into your 401k plan to pay off your debts?

January 16th 2013

The feeling of being overburdened with too many debts can be very nerve-wrecking. On one hand, you could be hounded by your creditors repeatedly, while on the other hand, you could end up being trapped under the burden of the debts for the rest of your life. You might be able to squeeze down your budget to some extent and make the minimum payments on your debts. But this way, you will be able to pay off only the interest, the principal amount will still remain unpaid. If you are in this kind of a situation, you might think of making an early withdrawal or taking a loan from your 401k account. Well, if you do so, you may jeopardize your post-retirement happiness and you may have to work longer than you expect to do.

How does withdrawal from 401k affect your finances?

You may think that the money in your 401k retirement account is all yours and you have the right to do whatever you want with it. Right you are. It’s all your money. Which is why, I believe you should be more cautious while spending it. Given below is an example on how you could actually lose money by withdrawing from your 401k account early.

Let’s say, you are now at the age of 30 and you wish to withdraw $21k to pay off your debts. Now, you actually need to withdraw an amount of $28k to be able to repay the debts! Why? Because your early withdrawal will be subject to a penalty of 10%. You will also have to pay income taxes on this withdrawn amount which could be 15% or more.

However, if you leave this $28000 money untouched in your retirement account and make your usual contribution to it, you will end up with a huge balance in the account and a substantial income post-retirement.

The 401k guidelines allow you to make “hardship withdrawal” without paying any penalty. But you need to face serious hardship in order to qualify for this type of withdrawal. Repaying your high interest consumer debts does not qualify as serious hardship. Thus, it is near impossible for you to avoid penalty and taxes when you withdraw money from your 401k to pay off debts.

Can you take a 401k loan to get rid of your debts?

Many employers allow you to borrow from your 401k account. This might look to be an attractive option as you will be taking money from your own funds and you will be paying interest to yourself. But there are some reasons why taking a 401k loan might not be the best options for you:

  • It will not eliminate your debt: You may take a 401k loan and pay off the existing debts, but the burden of debt will still be on you. You will have to repay the debt within a certain period of time, failing which the loan will be considered as an early withdrawal and will be subject to penalties and taxes.
  • Leaving the job would be difficult: In case you leave your current employer, you will have to repay the loan within 60 days. Otherwise, you will have to pay penalty and income taxes.
  • Your net salary would be lower: As you will repay the loan through payroll deductions, the net amount of your salary would be reduced. As a result of this, you may have to cut your monthly budget shorter. This could be quite tough for you given the financial difficulty you might already be facing due to the heavy burden of your outstanding debts.
  • Your retirement savings will be affected: While you would repay the 401k loan, it will be quite difficult for you to make contributions into the account. Some plans simply do not allow you to contribute into your 401k account till the time the loan is repaid. Thus, if you generally contribute $500 a month and it takes you 3 years to pay off the loan, you will miss out on $18k in 401k contributions as well as your employer’s matching contributions. To add to the loss, you will also miss out on the interest this money could have earned for you in the long run.

Do you have any alternatives to repay the debts?

You do not necessarily have to affect your retirement earnings to pay off your debts. There are other options to help you repay your existing financial obligations. If there is enough equity in your home, you may consider taking a home equity loan to consolidate your multiple debts. You may also enroll in a debt consolidation program or take advantage of a debt settlement program to get rid of the debts and live a tension-free life.

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