Paying off debt from credit cards and student loans gives you more disposable income to invest and to save for retirement. Selling personal items and liquidating accounts can generate money you can use to pay down your debt. Cashing out a 401(k) plan may free up some money to reduce your debt, but it's important that you understand the tax laws and consequences for cashing out your 401(k).
A 401(k) plan is an employer-sponsored retirement account. Payroll deductions make it easy for employees to participate, and some employers match their employees' contributions. Depending on the plan, employees can invest their money in a variety of bond funds and stock mutual funds. You may be able to contribute up to $17,500 per year to your 401(k) or up to $23,000 per year if you are 50 years old or older. With employee contributions, employer contributions and earnings on investments, your 401(k) account balance can grow quickly.
Generally speaking, the balance in your 401(k) account is tax-deferred. As long as you leave your 401(k) contributions and any matching contributions from your employer in your account, those funds are not included in your taxable income. Similarly, the earnings on your 401(k) investment funds are not included in your taxable income while the earnings remain in your account. Taxes, and, in some cases, penalties, become due when you withdraw funds.
The money you withdraw from your 401(k) plan is taxed as ordinary income to you in the year in which you withdraw it. With few exceptions, if you withdraw money before you are 59 1/2 years old, the plan administrator will withhold 20 percent of your funds for taxes. You will also incur a penalty equal to 10 percent of the amount you withdraw. Cashing out a 401(k) to pay debt is often not worth the effort because taxes and penalties will consume much of the money you withdraw.
If you withdraw money from your 401(k) to pay debt because of a financial hardship, your transaction may be exempt from the 10 percent penalty for early withdrawal. The IRS narrowly defines a hardship distribution as a withdrawal that is necessary to satisfy an immediate and heavy financial need of the employee. A distribution is not a hardship withdrawal if the employee has other resources available to meet the need. Examples of hardship distributions include withdrawals to pay for funeral debt, certain medical debt, tuition debt and debt to prevent eviction or foreclosure from a primary residence.
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