Should You Take Money Out of Your 401(k) to Pay Off Debt?

Peter Richardson is a vice president of Planning Excellence at Northwestern Mutual.

If you’re struggling with money or trying to pay off debt, it can feel like you’re just barely keeping your head above water. And if things get bad enough, it may be tempting to use some of your retirement savings to make things easier—especially if retirement looks far away. While this might help in the short term, it can create long-term problems.

Below, you’ll see the different ways you might be able use your 401(k) money and why you should be cautious about tapping into it before retirement. And you’ll learn when using your 401(k) to pay off debt might be a strategic move. You’ll also hear about a few other strategies that might help you out.

Can you cash out a 401(k)?

The money in a 401(k) account belongs to you. But because you’re getting a tax benefit, you may pay a price for tapping into these savings early. Here are a few ways to access your money.

Early 401(k) withdrawal

You could make an early withdrawal from the account, potentially cashing it out entirely. While this gets money in your pocket, it comes at a pretty steep cost. First, you’ll pay income tax on any withdrawal you make (and this could push you into a higher tax bracket). Second, you’ll pay a 10 percent penalty when you make a withdrawal before age 59½.

An exception known as the Rule of 55 waives this penalty for individuals aged 55 or older who leave their job for any reason and withdraw money from a 401(k). It applies only if the 401(k) is at their most recent employer. So this exception doesn’t include older 401(k)s, such as those with other employers.

And you might qualify for a hardship withdrawal if you can show an immediate and heavy financial need. Common qualifying expenses include:

1. Medical Expenses: Costs not covered by insurance.
2. Home Purchase: Down payment or closing costs for your primary residence.
3. Education Expenses: Tuition, fees and related educational expenses for you, your spouse, children or dependents.
4. Preventing Eviction or Foreclosure: Payments necessary to prevent eviction from your primary residence or foreclosure.
5. Funeral Expenses: Costs associated with the death of a family member.
6. Home Repairs: Certain expenses for the repair of damage to your primary residence.

You’ll need to pay income tax on the money you get, and if you are under the age of 59½, you may incur a 10 percent early withdrawal penalty. Not all 401(k) plans offer hardship withdrawals, and the rules can vary by plan. Check with your HR department or their contact for specifics.

401(k) loan

You could access some of your retirement savings by taking a loan from your 401(k). But you can do this only if the plan allows it. If so, you’ll usually be able to borrow up to a limit. Each 12 months, that limit might be either 50 percent of your vested balance or $50,000—whichever is lower.

When you take a loan from your 401(k), you’ll be required to pay it back plus interest over the next five years. Rates vary and are usually calculated by adding 1 to 2 percent to the current prime rate. (That’s a short-term interest rate used by banks.) If you borrow from your 401(k) when the prime rate is 7.5 percent, for example, you can expect the interest rate on that loan to be between 8.5 and 9.5 percent.

The good news is that any interest you pay goes back into your account, not to a lender. And you won’t face an early withdrawal penalty.

Stop or reduce contributions

Another way to get out of a tough spot could be to pull back on your 401(k) contributions. You could stop them completely or reduce them until your cash flow is better.

• Your HR department can give you the form or website if you’re using a payroll deduction.
• If your contributions work through a bank transfer, you can change or stop the transfer.

To minimize the impact to your retirement, it’s a good idea to have a plan to get back to your full contribution once you’re back on your feet. You might put a reminder in your calendar to keep yourself on track. If things are looking good, you could even try to catch up to your growth before you pulled back (as long as you stay within contribution limits).

Whichever route you go, it can help to talk over options with your Northwestern Mutual financial advisor. Together you can see how the changes will work in the context of your broader financial plan so that you’re confident it is the right decision.

Why not to use your 401(k) to pay off debt

Just because you can access the money in your 401(k) doesn’t mean you necessarily should. In most cases, it’s usually a better idea to stay invested and avoid making an early withdrawal.

As noted above, when you make an early 401(k) withdrawal, you’ll be required to pay income taxes on whatever you withdraw. Depending on your current tax bracket and how much you withdraw from your account, this could push you into a higher tax bracket, meaning an even bigger bite going to Uncle Sam. And unless the Rule of 55 applies to you, you’ll be hit with an additional 10 percent early withdrawal penalty on top of things.

That means you’ll usually have to withdraw more money than you need to pay your debt and still cover taxes and penalties.

On top of that, when you take money out of your 401(k), you’re missing out on the potential for growth in the market. That means you might be losing the advantage of time through compound interest.

To show how it could work, let’s consider a 45-year-old woman with $300,000 in a 401(k). If she earns a 7 percent annual return on her portfolio until the age of 67, she’d have nearly $1.4 million in her account. Now let’s say that at 45, she withdrew $100,000 from her 401(k) to pay down student loans, a car loan and credit card debt. When she retires, she’d have less than $930,000 in her account. The $100,000 cost her more than $400,000 by the time she retires.

When using your 401(k) to pay off debt might be okay

But there are some situations when taking money out of your 401(k) to pay down debt might be worth considering. These include the following:

You’re taking a loan and know you can pay it back

If you’re sure you will be able to pay it back, taking a 401(k) loan will usually be a better idea than making an early withdrawal. You avoid income taxes and penalties. While a 401(k) loan will reduce how much money you have in the market, that reduction will be temporary compared to a more permanent withdrawal. This can be really helpful if you have a large, high-interest debt.

You can avoid the early withdrawal penalty

If you’re at least 59½ years old—or if the Rule of 55 applies to you—you can make a withdrawal from your 401(k) without triggering the 10 percent early withdrawal penalty. You’ll withdraw less from your account to take out enough to pay off your debt, leaving more of it in the market where it can grow. But any withdrawal will mean you’re giving up on some growth.

You have other sources of retirement savings

Maybe you’re lucky enough to have significant retirement savings outside your 401(k), such as a pension, IRA or annuity. In that case, making an early withdrawal from your 401(k) may not put a comfortable retirement at risk. If this applies to you, it’s still a good idea to make sure you’re accessing your funds with the least hit on your taxes.

It’s high-interest debt

The higher the interest rate on your debt, the more likely it becomes that using your 401(k) to pay it off can be a good idea. This is especially true of credit cards, payday loans and other forms of bad debt that can carry interest rates as high as 25–35 percent—much higher than you could reliably earn from keeping your money invested. Think twice, though, about using your retirement account to pay down low-interest loans. And once the debt is paid down, work to make sure you don’t go back into this kind of debt.

It would help you avoid a worse outcome

Nobody wants to drain their retirement savings just to have to rebuild them, but there are plenty of worse outcomes. If you’re facing bankruptcy, foreclosure or severe medical expenses and have exhausted other options, then using your 401(k) may be warranted.

Carrying debt is causing too much stress

Finally, it’s worth noting that everyone’s financial situation, goals and priorities are different. Some people may value the peace of mind that comes with paying off their debt more than they value their 401(k) balance. If this is you, make sure you’ve considered other ideas before you hit your retirement account.

Other debt management strategies to consider

Before tapping into your 401(k) to pay off debt or plug other holes, you could consider:

• Taxable investments: If you have taxable investments in a brokerage account or other type of account, you can access those at any time. While you may own capital gains taxes on any profits, you won’t owe any other fees or penalties as you might by accessing your 401(k) early.
• Life insurance loan: If you have a permanent life insurance policy that has significant cash value, you might be able to borrow against that cash value. You’ll need to pay it back, or it will reduce the amount of money your loved ones get when you pass away.
• Health savings account (HSA): If you have an HSA, make sure that you’ve reimbursed yourself for all qualified medical expenses incurred after the account was opened. If you haven’t, you may be able to reimburse yourself and use that newly freed money to pay down your debt. (If you’re 65 or older, the money in your HSA can be used on any expense, not just qualified medical expenses.)

Managing your debt can be difficult, but that doesn’t mean you need to cash out your 401(k) to get debt-free. Keeping a budget, prioritizing your debts and making an extra payment whenever possible are all effective strategies to help you get debt-free. If you need help, your Northwestern Mutual financial advisor can talk over the best path toward paying off your debt, including borrowing or withdrawing from your 401(k). Your advisor can review your larger financial picture and help you find opportunities—and point out blind spots that you might otherwise overlook.

Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP^®, CERTIFIED FINANCIAL PLANNER^®, and CFP^® (with plaque design) in the United States to Certified Financial Planner Board of Standards, Inc., which authorizes individuals who successfully complete the organization’s initial and ongoing certification requirements to use the certification marks.