Should You Use Your 401K to Pay Off Debt?

By Jackie Beck   Updated 05/10/2021 at 7:27 am

You might be wondering, “Should I use my 401k to pay off debt?” It’s a common question.

Maybe you’ve got medical bills hanging over your head, and want to do a 401k hardship withdrawal to pay that debt. Or you’re thinking of using your 401k to pay off student loans, because you’re itching to get out of debt as fast as possible.

You’ve got money just sitting there, money that you aren’t using right now. Why not go ahead and use your 401k to pay off debt?

Because there are lots of good reasons not to, and you may regret it if you do.

Let’s talk about the pros and cons of using your 401K retirement money to pay off debt, and some rare cases where it may make sense. You’ll want to look at other solutions first though.

Benefits of Using 401k Money to Pay Off Debt

The biggest pro is simple: being able to use the money.

If you withdraw the money and use it for debt, you might feel a sense of relief at no longer having that debt hanging over your head. You might be able to afford day to day expenses more easily. You might be able to pay for life-saving surgery that you couldn’t otherwise have, or rebuild your house after a disaster.

But all of those boil down to the same thing: using the money for something important to you.

If you borrow from retirement to pay debt using a 401k loan (for example, to get out from under a payday loan) there could be another pro. If everything goes well, then that pro is paying interest to yourself. The interest you pay goes back into your 401k vs. going to whoever you owed it to before. And of course there’s no credit check required to borrow your own money. (There could be fees though.)

Finally, taking money out of your 401k does not hurt your credit.

So what about the cons?

The Cons of Using Your 401k to Pay Off Debt

The cons take a little more explanation, and there are a lot more of them.

The biggest con is that retirement money is supposed to be set aside for retirement. Even though it may be very tempting to tap into that money, it’s called a retirement account for a reason: it’s there to help you retire gracefully.

The money in your 401k isn’t found money, or extra money. It’s money you’ll need to draw on when you retire. Even if you never want to retire, many people are forced to retire due to job loss as an older worker or due to health issues at any age. You’ll absolutely need that money then, and your future self will thank you.

If you use it for something else now, you won’t have it later when you can’t work or don’t want to work. No one’s going to give you a retirement loan. And you will miss out on potential earnings over time that could add up to a LOT of money.

Some of the other cons are going to depend on how you get the money out of your 401k though. More cons will be listed under each of those ways.

So let’s talk about whether or not you even could get access to your 401k money first.

Can You Use Your 401k to Pay Off Debt?

You can only use your 401k money for debt in certain situations. If your plan allows them, there are 3 ways you might be able to use your 401k for debt.

You might be able to use it by taking:

  1. a hardship withdrawal
  2. an early distribution
  3. a loan

Each of those ways of getting money out of your 401k can only be done in certain cases, and there are rules to follow for each one. (From the plan itself, and from the IRS.)

Using 401k Hardship Withdrawals for Debt

Since retirement money is meant for retirement, not every 401k plan allows hardship withdrawals. You’ll need to check with your plan to see whether or not it’s allowed.

If they do allow it, it would only be for certain cases. You would need to show that you are eligible in order to be able to take money out of the plan as a hardship distribution. The IRS talks about those cases in more detail here, but the very short version is it must be:

  • Due to an immediate and heavy financial need.
  • Limited to the amount necessary to satisfy that financial need.

So you have to need the money right now, for something really important. Assuming you are the employee who has the 401k, some of the things that could qualify according to the IRS are:

  • certain medical care expenses
  • stopping eviction from or foreclosure on the home where you live
  • certain burial or funeral expenses
  • certain expenses for repairing damage to the home where you live if it was caused by a qualifying disaster
  • costs directly related to buying the home where you will live
  • tuition and related educational fees and expenses for the next 12 months of postsecondary education for yourself, your spouse, dependents, or beneficiary

You won’t be able to repay it or roll it over to another plan or an IRA if you take a hardship withdrawal.

Note that using your 401k to pay off credit card debt isn’t on the list. So you cannot take a hardship withdrawal for credit card debt. And using 401k money for a car loan or student loans wouldn’t be a hardship withdrawal either. (Although, again, paying for the next 12 months of college expenses could be.)

Cashing Out Your 401K by Taking an Early Distribution

There are times when you’re allowed to cash out your 401k early even without a hardship, but not very many of them.

Basically, the main reasons you can cash out your 401k early are if:

  • you are no longer employed by the company your plan is at
  • the 401k plan itself ends
  • you have a QDRO
  • you meet the rules for a coronavirus-related distribution and your plan allows it

For example, if you have a 401k at an old employer or are leaving your job, you can ask them to send you a check for the balance. It will normally be subject to a mandatory 20% tax withholding if you do that. (You can also do a direct rollover into an IRA instead, which is usually a good idea, but that’s a topic for another article.)

Another example is thanks to the CARES Act. With that, you can take a penalty-free 401k withdrawal of up to $100,000 on or after January 1, 2020 and before December 31, 2020 if you qualify. This is more than the usual amount allowed, and it will count as taxable income over the next 3 years unless you choose to have it count all at once. With this type of withdrawal, you are allowed to repay it if you can. In general, you qualify if you, your spouse, or dependent are diagnosed with SARS-CoV-2 or COVID-19, if you’re having money troubles due to the virus, and if your plan allows it. You’ll have to certify that you qualify to your plan.

But no matter how you do it, cashing out your 401k early instead of rolling it over usually has some pretty big downsides. We’ll cover those in the next section, and go over some of the cons for hardship withdrawals at the same time.

Cons of Doing a 401k Hardship Withdrawal or Taking an Early Distribution

When you really need the money, making a hardship withdrawal or cashing out your 401k early may seem like a good idea. But is it? Of course you’ll have to judge your for yourself based on your own life, but here are some cons to consider.

There Are Usually Tax Penalties for Withdrawing Money Early, So You Might End Up Owing Uncle Sam

If you withdraw money from your 401k before retirement age, you can be stuck owing the IRS money come tax day due to penalties and increased taxes.

Owing the IRS is bad, because the IRS has massive powers to collect money owed to them, including the power to levy and seize property.

You Could Lose a Lot of Money

If you’re under age 59½, you will be taxed on the money you take out unless you meet one of the exceptions. So if you take out money from your traditional 401k to pay off debt, you can lose a LOT of the money you withdraw to taxes and penalties. Maybe even as much as 40% of it, depending on how high your taxes end up being.

40%! That’s like throwing away 40 cents of every one of your hard-earned dollars.

Put another way, on a $10,000 withdrawal you could have to pay $4,000 of your money to the government in order to get to keep $6,000 of it.

Why so much?

Because unless you meet one of the exceptions (for example, for hardship, coronavirus-related distributions, separation from service, etc.) you’ll have to pay a 10% additional tax. And either way, some or all of the money you take out will be taxable.

So that’s a 10% early distribution penalty PLUS the applicable tax rate for your now-higher income level. Your income increases because the distribution itself will count as additional income for the year. Which means you’ll very likely pay even higher taxes than normal, too. It may even change your tax bracket.

While it’s true that you would still have part of the money, would you feel good about it if a stranger accessed your checking account and withdrew a big percent of your money today?

So while it may be tempting to take that cash and pay down debt, cashing out your 401k is really just a good way to lose money that you could otherwise have kept.

It works just a little differently if you are taking the money out of a Roth 401k, but there are still taxes and penalties to consider.

Either way, consult a tax person that knows your situation if you’re thinking of doing this.

You Could Miss Out on Future Earnings

In short, cashing out your 401k simply to pay down debt could be robbing your future self. That’s because in addition to the cash you’ll lose in taxes and penalties, you could also lose out on the wonders of compound interest and/or investing over time.

Those are things that could put a huge amount of money in your pocket over time.

Rolling over your money to an IRA is usually a much better option than cashing out your 401k for debt reduction. It’s not really even much trouble, especially if you do a direct rollover. Doing a direct rollover means that you never have to handle the money yourself.

If you have an existing IRA, it’s often just a matter of telling your employer that you want to do a direct rollover to that IRA. If you don’t already have an IRA set up, it doesn’t take much paperwork to get it done. Then you can go ahead with a direct rollover to that.

If you take money out due to a hardship, you also usually won’t be allowed to contribute to your 401k plan for a period of six months after you do so. Again, that reduces the time for possible earnings.

One More “Con” to Be Aware of for 401k Hardship Withdrawals

If you’re thinking of doing this, you likely really do need the money. I’ve been there, and I know it’s really hard, to put it mildly. But there’s one more con I want to point out out regarding 401k accounts:

In general, money in qualified 401k accounts is protected from creditors.

This is because of the Employee Retirement Income Security Act (ERISA), which is a federal law. If you aren’t sure if your 401k is a qualified account, talk to your plan administrator.

So personally, if I were looking at making a hardship withdrawal from a 401k to pay for past medical care or to prevent eviction or foreclosure, I’d want to be sure I’d used up my other options first.

I would do things like setting up payment plans, negotiating, and earning extra money that could be used instead.

Once those methods were used up, I’d want to think long and hard about whether the withdrawal was actually likely to help over the long run. If it was only a short term fix, and I was likely to end up declaring bankruptcy anyway, I wouldn’t do it. I wouldn’t want to trade what I’d built up for my future for a short-term fix that was unlikely to make a lasting difference.

In other words, I wouldn’t want to use up my retirement money and then STILL declare bankruptcy, lose my house, or get evicted because I hadn’t yet found a new source of income. For me it would be better to at least have money left in the 401k for the future.

Your situation could be different, but it’s something to think about.

Cons of Taking Out a 401k Loan to Pay Off Debt

Ok, but what about a loan, you might ask. The answer to “Should I borrow from my 401k to pay off debt?” is very likely no.

(And if you’re thinking of taking a loan from a former employer, very few employers allow this. You usually have to be a current employee.)

There are limits on how much you can borrow, and rules for paying it back. The IRS says that “Generally, if permitted by your plan, you may borrow up to 50% of your vested account balance up to a maximum of $50,000. The loan must be repaid within 5 years, unless the loan is used to buy your main home. The loan repayments must be made in substantially level payments, at least quarterly, over the life of the loan.”

If you qualify under the CARES Act, you may borrow up to a maximum of $100,000, and the due date to start paying it back is delayed for one year.

But a huge con with a 401k loan is that if you lose your job or the 401k plan ends, you could be in deep doo-doo. That’s because if that happens, the 401k plan can require you to repay the entire loan in full within a limited amount of time. If you don’t repay it in time, it gets treated as a distribution. (With brings the associated taxes and penalties.)

Depending on when that happens, that could be very little time. The IRS states that “you have until the due date, including extensions, for filing the Federal income tax return for the taxable year in which the offset occurs.”

This is the case even if you leave your job involuntarily — such as if you get laid off or fired.

Most Importantly, Borrowing or Withdrawing from a 401k Probably Won’t Solve Your Debt Problem

This is because paying off debt in a lump sum from 401k money can be similar to what happens when you consolidate debt.

When you consolidate, you feel better, and so don’t change your habits. You end up right back where you started from in a relatively short period of time. Only now your retirement account is decimated, too.

You probably don’t think any of those things will happen to you. But they can and often do.

If it happens to you, not only will you owe even more money than you borrowed to begin with, you’ll have lost money that could have made an enormous difference in retirement.

Assuming that risky things won’t happen and failing to plan for the worst are the exact actions that cause debt to begin with. (Of course, if you’re talking about a literal life or death situation and have no other choice, that’s when it can make sense.)

What About Using a 401k Withdrawal to Pay Off Credit Card Debt?

If you ask me, it’s a bad idea. Withdrawing money from your 401k to pay off credit card debt is using retirement money — money you’ll need later! — in order to pay for unsecured debt, from an account that’s usually protected from most creditors. Plus it’ll cost you.

What Using a 401k Loan to Pay Off Your House?

It can be tempting to borrow from your 401k to pay off your mortgage, assuming you owe less than the maximum amount you can borrow.

In principle that can seem like a good idea, because you would be paying interest to yourself instead of a lender. But since you usually can’t contribute to your 401k while you are repaying the loan, you’ll miss out on setting aside more money for retirement. (Plus any potential earnings or employer contributions.)

And the same cons of a 401k loan listed earlier in this article apply too.

The Bottom Line

Jim Blankenship, CFP® and founder of Blankenship Financial Planning sums it up nicely:

Using a 401(k) or IRA funds to pay off debt can make your financial issues worse, rather than resolving them. By taking a withdrawal from one of these accounts before age 59 1/2 (in most instances), you’ll be taxed AND penalized 10% on the withdrawal. So a withdrawal of $1,000 could wind up costing you $320 if you’re in the 22% tax bracket. And that doesn’t account for state income tax, which may apply depending on your state.

On top of the outrageous tax cost of the withdrawal, by withdrawing funds from your retirement plan for something other than retirement, you’re derailing the savings that you’ve worked so hard to build up. That $1,000 withdrawal mentioned above could take you quite a while to replace in your account. In the meantime that money is not invested, causing you to miss out on the growth that you could be gaining from the investment. If it takes you a year to replace the money and your account is otherwise growing at 8% per year, that’s another $80 added to the overall cost of your withdrawal, for a total of $400, or 40%.

At that kind of “cost”, you can see that it makes a lot more sense to look at all other alternatives for paying off debt (sell something, earn money from a side-hustle, etc.) rather than taking it from your retirement plan.

If You Really Want to Get Out of Debt, Consider Other Options

Don’t go for the “easy” way, especially since that usually turns out to be the hardest way. Instead, change your habits. Stop borrowing money. Start using the debt snowball method. Create a spending plan and an emergency fund. Stick with it, because you can do it!

Yes, it’s super frustrating to have to wait to get your debts paid off, and to have to do what it takes to get there. But it’s also AWESOME, because taking the time to make a permanent change like that improves your life for the better in so many ways. It’s worth it. And it usually ends up being faster, too.

It’s only by doing the work that you can truly reap the long-term rewards that come from being debt free. Yes, it absolutely can be (and often is) a struggle to get out of debt. It may not be a whole lot of consolation now, but the things that you struggle with often leave you with a lasting positive impact.

Do what it takes to get of debt by changing your behaviors. Both you and your 401k account will be better off for it in the long run.

And remember, no matter what you decide, be sure you understand what could happen. Get good advice from a pro who knows your situation and the laws.

Should You Use Your 401K to Pay Off Debt?

One thought on “Should You Use Your 401K to Pay Off Debt?

  1. I generally agree with your article but have one special case to add. If your employer offers a 100% 401k match up to X amount of dollars. It is better for you to put the money into your 401k and take the 100% match and then pay the early withdrawal penalty and taxes on it if you need the money now than it is to forgo the 401k contribution and match because you need the money for an immediate bill.

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