Is it worth using 401k to pay off your debt and paying your debt using the 401k investment plan? If you have heard anything about the program, you must be familiar with the plan’s details.
This is a common plan offered by employers. If you accept the conditions, you will have some money in a separate account for your retirement. But is it possible to use the money for a different purpose, namely for credit card debt payoff? This is the question to be answered in the article.
There are conflicting opinions on using a 401k plan to deal with debts. Experts claim it is a plausible option, but it also might have outcomes in the future. It’s time to check out more about the plan and see if paying off debt is technically possible.
What Is a 401k Loan?
Before you learn whether it’s a good idea to pay the debt using 401k, let’s remind you what the program is about. 401k is a plan offered by employees and is focused on retirement savings or investments.
If you as an employee agree to the 401k plan, a certain percentage of your monthly income is redirected to your savings account.
You can benefit from the 2 most common types of a plan. There’s a basic type and a Roth option, each of which is different in terms of taxation approach. The former plan imposes taxes on withdrawals.
However, the Roth plan offers tax-free withdrawals with no tax deduction during the investment period. These are called pre-tax and after-tax plans consequently.
How Does a 401k Loan Work?
To find out how taking money from your 401k plan can work, you should understand how the program works. Let’s break the working principle into pieces to make it clearer for everyone.
- The first step is the agreement with the employer. In recent years, the popularity of the pension form went down, giving way to the 401k retirement plan.
- Once the agreement is achieved, there has to be a choice made between the two main plan options described in the paragraph above.
- The contributions are made in the form of automated money transfers from the monthly paychecks.
The employee can choose the funds where the money is invested. In a nutshell, this is a traditional system beloved by many in the country.
How to Pay off Credit Card Debt Using 401k
The working principle is more or less clear. But there’s an important question that needs answering. How to cash out money to manage the debt? In short, 2 options are open for the customers.
If you decide to use your 401k plan to cover your debt, you have to familiarize yourself with the withdrawal and loan feature. Let’s get to the details and see how the system works in real life.
401k Withdrawal
There’s a simple Withdrawal procedure that implies certain inconveniences for the customers. If you haven’t turned 59, you will be required to manage a 10% withdrawal penalty. Furthermore, income tax should also be covered in this case. But covering the penalty isn’t necessary if you meet the following criteria.
There’s a rule called Rule of 55, which relates to the person’s age. If you don’t work for the company managing the 401k, and you left the company before you turned the age of 55, the penalty isn’t applied to your account.
This is a common rule people try to stick to because a 10% penalty is a huge sum spent as a fee for a transaction.
401k Loan
Let’s look at another method for paying off debt. When you apply for a loan, you borrow from an account. The amount of money depends on the agreement with the employee.
On average, this point can reach up to 50% of the total sum. However, $50.000 annually is a restriction that has to be obeyed.
The perk of getting yourself a loan lies in no taxes or penalties. Furthermore, the interest will get to your account soon, so your losses are minor. However, leaving your current job means you will be required to repay the loan within the shortest time frame. And this point doesn’t fit everyone.
Read Also: FIRE Movement: The Hard Truth About How To Retire Early
What to Consider Before Using 401k To Pay off Credit Card Debt
Many people agree that paying with the investment retirement plan is worth it. In some cases, it might be the only option when no other choices are left. However, no matter why you decide to stick to the point, certain risks must be considered.
There are minor issues that can hamper the procedure. These issues discourage some employees from commencing the procedure. Hence, you should be ready and get familiar with the specificities.
Check Eligibility
If you choose 401k to pay off debt, make sure you find a good reason for the withdrawal procedure. The account can’t be used for no reason. If you have a convincing reason why this money is obligatory in your case, you should use it. However, keep in mind that taking money without a serious purpose won’t work out well.
- Medical expenses.
- Higher education tuition.
- Home repair after a confirmed disaster.
- Funeral costs.
These are some of the reasons that will make it easy to withdraw money. You can check out if your personal case refers to other reasons stated by the 401k plan.
Assess Current Financial Situation
Can you assess objectively what your current financial state is? Financial experts admit that using the money from the account must be a matter of urgency. If you can’t find other ways to get money fast, the use of a 401k to pay off is a good point.
However, when there are other options available, it’s better not to touch the investments. Otherwise, it will shake financial stability and vanish all retirement guarantees for the future.
Calculate How Much of the Retirement Is at Risk
Keep in mind the money you will lose on the deal. Whether it’s Withdrawal or Loan, there are penalties and taxes to eat your money fast. Don’t forget to learn in detail about the credit debt you are obliged to manage, and the interest you have to cover.
In the previous paragraphs, you can find information about the Rule of 55. If you check the details on your personal case, there might be ways to avoid expensive penalties and taxes.
What Are the Rules for 401k Withdrawal?
If you prefer using a Withdrawal feature, you should familiarize yourself better with the requirements and rules. When employees don’t know the details of the deal, they often lose the game. Hence, let’s check what the best way to properly get money from the investment plan is.
Withdrawals Before Age 59½
If you decide to cash out money before you turn 59, there are certain restrictions for the users. First of all, you will be required to cope with a 10% penalty on a withdrawal procedure.
And your regular income tax will be added to the sum, too. Hence, if you plan to take your money from the 401k to cover the debt, you should beware of the money-related issues and expenses.
Withdrawals After Age 59½
The situation changes dramatically when you turn 59 years old. This is what the retirement package and account is meant for. When you reach the necessary age, you don’t need to cover extra penalties for withdrawing money.
However, people should understand how the system works. If you decide to take your money, no penalties or extra charges are used. But contributing to the account isn’t possible anymore if you stay from withdrawing the money.
When Should I Use a 401k to Pay Off Debt?
If you don’t want to cause certain financial issues and are overdue, you should keep in mind the following details. First of all, withdrawing a portion from your account isn’t worth it, when you are under 59 and dealing with a low-interest rate case.
For example, it could be a mortgage or college tuition. Why can’t it work out? You will overpay a lot to consider the transaction a success.
However, there are cases when paying off your debt using a 401k withdrawal might help. If there are any urgent situations, such as funeral costs, house repair after a huge detrimental disaster, or medical issues, it might be a prerequisite to use the Withdrawal.
Read Also: 15 Types of Loans for Retired Seniors
Pros and Cons of Paying off Credit Card Debt Using 401k?
Are you still interested in the opportunity to have your money withdrawn from your account? Then the comparison might help you come to the right conclusion. Let’s check what advantages to the clients the Withdrawal option can offer.
- By cashing out the money from the 401k program, you get immediate access to your funds. There is no need to wait until the bank approves the deal or verifies the transaction.
- Cashing out money from the account might prevent you from falling into another debt until you div out the new financial situation and start gaining profit. It applies to people under 59 in most cases.
- A tax deduction is another benefit because you manage taxes only for what you take out.
Are there any cons if you choose 401k to pay off debt? This is a double-sided sword where you have to accept both pluses and minuses of the offer.
First off, the taxes and penalties for applicants between 55 and 59 years old will hit your budget and make you waste some money. Second off, there must be a good reason to cash out some money.
| Advantages | Disadvantages |
|---|---|
| Immediate access to funds | Penalties between 55 and 59 |
| No issues with debts anymore | No cashing out without a serious reason |
| Tax-deduction | Restrictions and limitations |
Bottom Line
Covering your debt with the help of the money from the investment account might be a lifesaver in certain cases. This is a common account that helps people collect some money for the retirement period. However, life is unexpected, and borrowing money is the only way out in many cases.
For this reason, many employees consider their 401k account to help them in urgent cases. In the article, you can learn what offers exist and how to meet the requirements, and get your funds easily accessed.
Furthermore, you can now understand what restrictions and penalties are imposed on those trying to withdraw money.
If you have not grasped the main idea behind paying off debt with the help of the investment plan, you might get help from reading the following answers. Let’s see what the answers are.
Sources Used in Research for the Article:
- Considering a loan from your 401(k) plan, IRS, https://www.irs.gov/retirement-plans/considering-a-loan-from-your-401k-plan
- Loan Guide for the 457 & 401(k) Plan, NYCDCP, https://www.nyc.gov/assets/olr/downloads/pdf/deferred/loan-guide.pdf
- 401(k) Plan, Investor.Gov, https://www.investor.gov/introduction-investing/investing-basics/glossary/401k-plan