Using a 401k Withdrawal or Loan To Pay Off Debts

by Gary Foreman

Have you hit hard times? Struggling with paying your credit card debt? Consider these pros and cons before you take out a 401k withdrawal or loan to pay off your debts. Another option for tackling your debt may serve you better financially.

Gary,
I need some advice. My credit card debt is becoming a problem. Ever since they cut my hours at work, I’ve only been able to pay the minimum. My balance is $9,700. It’s been growing a little each month. I’m thinking of making a withdrawal from my 401k to pay off the credit cards. I’d do it except for the penalties and the fact that I just turned 40, so I’m starting to think about retirement. What should I do?
Nick

This is a good question and one that’s frequently asked. Money that we’ve stashed away in a 401k plan looks tempting, especially when we’re struggling to make the minimum payments. Let’s see if we can help you decide whether to raid that 401k to pay off your credit card debts.

What happens when you withdraw money from your 401k?

Let’s begin by seeing what happens if you pull the money out of your 401k and use it to pay off credit card balances.

Any money that you take out will be subject to ordinary income tax. For illustration, we’ll assume that you’re in the 25% tax bracket.

And, unless you qualify for a hardship exception, you’ll also pay a 10% early withdrawal penalty.

It’s unlikely that you’d qualify for a hardship. According to the IRS, a hardship is defined as: “Certain expenses are deemed to be immediate and heavy, including: (1) certain medical expenses; (2) costs relating to the purchase of a principal residence; (3) tuition and related educational fees and expenses; (4) payments necessary to prevent eviction from, or foreclosure on your residence.

So it’s probably true that you’ll lose 35% of any money withdrawn to the IRS. We’ll also assume that you want to end up with $10,000 (the math is much easier to illustrate).

Determine how much you’ll need to withdraw from your 401k.

The formula to determine what to withdraw is the amount of money you want ($10,000) divided by the percentage of the withdrawal you get to keep (in this case 1 minus 35% = 65%). So $10,000 divided by .65 = $15,385. You’ll need to take out over $15,000 from your 401k to pay off the cards.

If you do that, the benefits are clear. You won’t have that credit card balance haunting you each month and you won’t need to make that money credit card payment. But the costs are harder to see. Let’s see if we can’t quantify them.

Consider the future costs of the withdrawal.

Many who make a 401k withdraw fail to consider how it will affect future wealth. That’s because you won’t face the costs until you retire.

To illustrate, we’ll assume that you were able to earn 5% on that money if you left it in the 401k. At that rate, the money would double every 14 years. So by the time you retire in your late 60s, it would have doubled two times and would be worth about $60,000.

Most retirement experts say that you can safely take about 3% of your principal each year in retirement. So that $60k would be about $1800 per year or $150 a month for the rest of your life and still leave the original $60k as an inheritance for your kids.

A 401k loan is different than a 401k withdrawal.

Let’s try looking at a different option. Suppose that instead of taking a withdrawal you choose to borrow from your 401k. Because it’s a loan and not a withdrawal, you won’t pay taxes on it.

There will be an interest rate applied to the loan. Check with your plan administrator to find out what the interest rate will be.

For our purposes, let’s say it’s the same 5% that you would have earned had the money been invested elsewhere. As long as that’s the case, the amount of money available when you retire will be the same.

But it is possible that today’s monthly debt payments will be lower. Your HR department will be able to tell you what your new payment will be. You can compare that to your current credit card payments.

However, those lower payments don’t come without a risk. Generally you need to repay the whole 401k loan amount if you leave your job, so you’re stuck in your job until the loan is repaid. And, a layoff could be a real problem.

Consider other options before using your 401k for debt.

Another possibility would be to check out non-profit credit counseling. If you qualify, they can get a reduced interest rate and a lower payment for you. We created a checklist to help you determine if credit counseling is right for you. You will also find the contact information for a few trusted credit counseling agencies we recommend.

A final option would be to find a way to make up for the lost hours via a part-time job. Use the money to pay down your debts.

Ultimately that might be the best option. If your expenses regularly exceed your income, you’ll continue to have a debt problem. Even if you wipe the slate clean today, you’ll only start building a new balance next month. Soon you’ll be back where you are now.

Related:

• How a 401k Loan Affects Future Wealth
• Use a Personal Loan To Consolidate Credit Card Debt?
• What Does My Debt Cost Me?
• Staying Motivated to Continue Digging Yourself Out of Debt

Reviewed November 2022

About the Author

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.