Can You (and Should You) Use Your 401(k) to Pay Off Your Debts?
Debt is an overwhelming topic to say the least. While many people have a handle on paying back their outstanding loans and credit card balances, millions more are struggling to make their minimum payments every month and just get by in general. When situations get particularly difficult, many considering using their 401(k) savings plans to pay off the rest of their debt. Doing so is certainly an option, but, at the end of the day, is doing so really worth it? Consider the following when making your decision so you can get the best debt relief solution for your situation.
Cashing Out Early Puts a Toll on Your Taxes
Even though the 401(k) is in your name, it is not easily available before it reaches maturity. Choosing to take out money before you reach the age of 59-and-a-half will hit you with significant fees that you will be forced to pay, and they are usually pretty hefty. The first fee is a 10 percent tax penalty on whatever you take out too early. So, for example, if you want to withdraw $10,000 to put towards credit card debt, you will then have to pay an additional $1,000 fee.
Taking out the money also affects your taxes. Because you are technically receiving additional income, you have to claim the cashed out amount when filing and will have to pay an income tax. Depending on how much money you withdraw, it may even put you into a higher tax bracket, which means you will pay a higher amount on your yearly income than you would have if you did not withdraw. For many people, this can be an increase of up to 10 percent, which means they could potentially pay thousands more at the end of the year in federal and state taxes.
You Have to Pay it Back Within Five Years
To avoid those fees associated with using your 401(k) to pay off debt, you could take it out as a loan. Essentially, this will allow you to pay yourself back and protect your retirement funds. You will, however, have a repayment period and interest rate that will dictate how that money is returned to the account.
The repayment period for the amount cashed out is usually five years and the interest rate varies upon the loan market but will usually be between four and five percent. While that may not sound bad for a personal loan, it can make a mess of your 401(k) and even your monthly paychecks. Many employers choose to withhold the monthly payments toward your 401(k) from every paycheck to ensure it does get paid back upon the terms agreed, which means you will see less money each month to help pay for your day-to-day expenses. And while you are technically going to see less money in your paychecks, you will not be able to claim less money on your income for the next tax season because those missing funds went back toward your 401(k) loan.
It Reduces Your Retirement Savings
Just because the answer to “Can I use my 401(k) to pay off debt?” is yes does not necessarily mean that you should go down that route. Because you may have to pay back any amount you borrow from the plan or pay the fees associated, you will be spending a fair amount of time simply replacing money you took rather than adding contributions to the fund.
In the end, this can cost you thousands of dollars of additional savings that would receive no tax penalties or fees in the future. You should do all you can to protect your retirement from debt. That may mean finding a different solution to your financial hardship. This could be a consolidation loan that will combine some of your current debts (and will still require you to pay monthly payments and interest fees) or a debt settlement negotiation that may allow you to lower how much you owe by half!
Changing Employers Does Not Change What You Owe
Some things are just not meant to last forever. Millions of people switch jobs every year for better career opportunities, but if you do so when you have an outstanding 401(k) loan with a previous employer, it can make things a little more complicated. If you decide to completely end the relationship with the employer who issued the 401(k) loan while you still owe money, the outstanding balance will then be considered a taxable distribution and you will have to pay high fees that can severely damage your financial status in between jobs.
You Can End up in Worse Debt Than Before
All those fees and repayment plans are not always what they are cracked up to be. For many of those who choose to cash out their retirement savings plan, they find that doing so ended up costing them more money and very little of what they took out was actually able to be applied to outstanding debts. If they took out a $10,000 loan from their 401(k), for example, there is a good chance they only saw about $7,000 to $8,000 of it and that amount barely put a dent in the other debts they owe. They now have to pay that full $10,000 back along with their other outstanding debt.
Get Advice from the Specialists
401(k)s are confusing and can take a lot of navigating through the fine details to truly understand the ins and outs of the plan. If you are considering using your 401(k) to pay off debt, talk to Liberty Debt Relief to find out if that is the right course of action for you and what alternatives are available. Contact us today to get started on finding the debt relief plan that is best for your situation.