It can seem like paying off your debt is a never ending process.
It can be difficult to choose the best solution from all of the debt-repayment strategies, tools and tactics available. From balance transfer cards to consolidation loans, it’s hard to know which one is right for you. You may want to consider using your 401 (k) account to repay debt. Cashing your 401(k), early, can be costly in terms of penalties, taxes and possible financial gains. Many people avoid this option, but there are certain circumstances when it is a wise choice.
Borrowing from your 401(k).
Let’s first establish what you can do with a 401 (k) retirement plan even before your retirement. You have two options: A withdrawalor loan.
Withdrawal from a 401(k).
Early distributions of your 401(k), with some exceptions due to qualifying hardships or specific circumstances are both subject:
- In most cases, federal taxes are automatically withheld at 20%.
- Taxes of 10% (also referred to as a penalty for early withdrawal)
Your withdrawal will be taxed at the standard rates even if you qualify for an exception due to your particular need or circumstances.
A 401(k), withdrawal has another downside: Once the money is taken out of your account, you’re done with it. Compound interest may be lost, as it is calculated based on your balance principal plus interest accrued over the years.
Loans for 401(k).
The difference between a loan and a withdrawal from 401(k), is that the money taken out of your retirement account must be paid back eventually. Remember that some plans do not allow 401(k).
You can take early advantage of retirement savings with a 401(k). Borrowing against retirement is a better option than securing personal loans, because any interest paid is returned to the plan, instead of being charged to a lender.
A retirement plan typically allows for borrowing either:
- Plan value up to 50%
- You can claim up to $50,000, whichever is less.
Remember that you must repay 401(k), unless the loan proceeds are used to purchase a primary residence. Check the fine print of your plan before you decide whether or not borrowing from your 401(k), is right for you.
When to cash in your Your 401(k).
What are the risks of withdrawing from your 401(k), to pay debts? Short answer: it depends.
If debt causes daily stress, you may consider drastic debt payoff plans. You should run some financial calculations before you withdraw money from your 401(k).
How to:
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1. Check your eligibility
You’ll probably be charged a fee if you withdraw funds from your 401 (k) too early. There are some exceptions that the government allows.
You may be able to take money out of your 401(k), for example, if you have “an urgent and severe financial need.”
The hardship withdrawals can be used for medical costs, fees to attend postsecondary education, payments that prevent foreclosure or eviction or funeral or house repairs.
You cannot withdraw more money than you need to meet the financial needs. The need for financial assistance must be demonstrated, and you will also have to prove that there are no other sources of income that can satisfy it.
You should be aware that not every plan offers 401(k), so you may want to think about this option. You can check your 401(k), or speak to a financial advisor, to see if you are eligible.
2. Take a look at your financial status
Assess your financial situation once you know if you are eligible. What is your debt? Use a budgeting calculator to determine how much you can allocate to your debt.
If you have a $2,500 credit card balance and an income that is steady, it may be possible to reduce your debts by changing existing habits. You could save a lot of money by cutting the cord on your cable, streaming or TV services.
If you are on the brink of financial disaster, however, then a strict budget might not suffice. When you’re facing a financial crisis, utilizing your 401(k), may be a good option.
3. Calculate the amount of retirement that you may lose
The government is trying to encourage you to set up a plan to help your financial future. You may be required to pay penalties and taxes on your early withdrawals. Tax rates are determined by federal and state income taxes in the place where you live.
Say you are in your 20s, and have about 40 years before you want to retire. You withdraw $10,000 for your student loan payments. If you assume a 20% federal automatic withholding, a 4% state tax, and a 10% fee for the penalty, then your $10,000 withdrawal would be $6,600. This additional expense of $3,400 would be deducted.
There will also be less left for future investment.
Bottom line: You will be charged significant fees no matter how much money you withdraw from your 401 (k) early. The fees can include state and federal taxes as well as penalty fees.
How can you pay down debt using your 401 (k)?
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Consider the pros and cons of withdrawing funds from your 401(k) before you do.
Pros
- You may be able to pay your debts sooner than expected: This is possible in some situations. You may be able pay your account off in full by putting the 401(k), withdrawal, towards your debt. You can save money in the future by avoiding monthly interest.
- You may save more: If you are able to repay your debts with an early withdrawal, your budget could have more room. You could save more money if you had extra cash each month. Consider putting money into a high-yielding savings account.
- You may have less stress due to money: Your debt can cause daily stress. You can save mental energy by increasing debt repayments with a loan or 401(k).
- You may be able to have a higher income available: By paying off debts you could have greater financial freedom. This flexibility may allow you to reach a financial goal, such as saving for a home.
Cons
- A higher tax bill may be incurred: Your early withdrawal could result in a large tax payment. When you withdraw your 401(k), it is treated as regular income. The amount of federal and state tax you pay is determined by your income and where you live.
- You may be charged a penalty: A 10% fee will be deducted from the distribution of your 401(k) to discourage cashing it out.
- Can reduce your earnings from investments: Your 401(k) may generate investment returns. You’ll earn less over time if you withdraw your money.
- Can delay retirement: Withdrawing money from your 401(k), you may damage your financial future goals. You may find that your retirement fund is less full, resulting in a lower retirement income. This could cause you to delay your retirement.
How to get rid of debts without using your 401(k).
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You can use several strategies to achieve your debt-free goal without having to dip into your 401 (k). It may be difficult to pay off your debt, but you will benefit in the long run.
1. Interest rates and bills can be negotiated
You can lower the rates of your high-interest credit cards by calling your card’s customer service department. Compare your interest rate with those of competitors and the account history. Call your credit card provider and ask about your history.
You can ask your card provider to match a competitor’s offer if you discover a credit card that offers a lower rate. Lower interest rates can save you money on interest.
If you are in financial difficulty, your doctor may be willing to offer a payment plan without interest.
2. Use windfalls to pay off your debt
Consider paying off your debts whenever you get a bonus, tax refund or any other financial windfall. You could receive a bonus or raise every year, get a tax refund, or even have monetary gifts given to you by your family.
This supplemental income can be used to reduce your interest costs or release money from your budget.
3. Transfer your balance to a credit card with low interest
Consider transferring your high-interest credit card bills to a card that allows you to transfer the balance.
You can save money on your interest, but it will not eliminate all of your debt. You may have to cover the balance transfer fee if you cannot find an issuer who will waive it.
4. Personal loan
If you qualify, a personal loan can help consolidate your debts into monthly payments that are more manageable.
A personal loan is a form of installment loan. It has a fixed rate of interest and monthly payments that are predictable, just like an auto loan.
5. You can borrow against your equity
You can also use the equity in your home to repay debt.
This can be done by taking out an equity loan or home equity line-of-credit (HELOC). Remember that your house is the collateral for this debt, and you may lose it if you default.