Using 401(k) funds to pay off debt is usually not the best money move to make, especially if you have not yet reached retirement age. Paying off debt with 401(k) money when you are younger than 59½ will cost you some combination of interest payments, taxes and penalties, depending on how you access your retirement funds. It also sets you back in reaching your retirement savings goals. If you need to access your 401(k) funds to take care of a debt problem, however, you can do it.
Read through your 401(k) plan document and summary plan description, both of which are available from your employer. It’s important to know what options are available to you under your specific 401(k) plan. If you have already left your employer -- or if your employer has left you -- roll over your 401(k) funds to an IRA where you can access the funds more easily.
Borrow money from your 401(k). Assuming you’re still with your employer, and assuming the employer’s plan allows it, borrowing money from your 401(k) has some advantages over simply withdrawing it. The biggest benefit is that you will not have to pay income taxes or a penalty on the money, as long as you pay it back it back within five years. If you decide to borrow money from your 401(k) to pay down debt, you’re in luck. According to the Profit Sharing/401k Council of America, over 90 percent of 401(k) plans allow borrowing by the plan participants.
Make a withdrawal from your 401(k). If you’re using the money from your 401(k) to avoid foreclosure, pay medical expenses, pay for college tuition or pay for a family member’s funeral expenses, you may be allowed to make a hardship withdrawal. The IRS allows 401(k) plan sponsors to allow for hardship withdrawals, but it doesn’t require it. Still the vast majority of plans -- 85.6 percent -- allow hardship withdrawals, according to the PSCA. Making a hardship withdrawal is the most costly way to access your 401(k) moneys because you will owe taxes on the money -- assuming it’s not a Roth 401(k) -- and in most cases a 10 percent penalty, as well.
Apply the funds to your debt. Getting access to your 401(k) funds is the most difficult part of the process. Once you have the 401(k) funds, you simply need to apply them to the debts that you need to pay.
- You will owe interest, taxes and penalties if you borrow or withdraw money from a 401(k) plan before age 59½.
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- The Advantages of Rolling a 401(k) Into an IRA
- The Pros & Cons of 401k Withdrawals