Paying Off Your Debt Using a 401k Loan

by Rick Pendykoski

By tapping into your 401k, you can wipe out your debt. And that’s not a bad thing. But it has consequences. Know what they are before you decide to take out a 401k loan.

It’s no secret that the American debt situation is overwhelming. According to The Motley Fool, the average credit card balance in 2022 is $5,910. And 43.6 million student borrowers owe an average of $37,718 each. (source: EducationData.org)

Most of us are trying to get out from under some amount of debt.

But should you use your 401k to pay your debt?

The Significance of 401ks

A 401k is a great retirement savings tool that offers tax benefits, too. The money is taken directly from your paycheck before the taxes are withdrawn, thus reducing your taxable amount, eventually leading to you paying fewer annual taxes. The money is automatically taken from your paycheck, so you are less tempted to spend those funds. And another significant benefit is that your employer can match contributions, which is practically free money.

Generally, 401k distributions/withdrawals are allowed when

You turn 59 1/2 years.
You become disabled, can no longer work, or you die.
Your employer decides to terminate the plan with no replacement.
You want to withdraw because of a financial hardship. However, not all employers allow withdrawing money from 401k due to financial hardship.

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Early Withdrawal Penalties

The IRS allows you to withdraw money from your 401k after you turn 59 1/2. If you take out money before that age, you are charged a 10% penalty and must pay federal and state income taxes on the withdrawn funds. At age 73 and above, you must begin taking mandatory withdrawals from your 401k.

When Does Taking Money Out of a 401k To Pay Debt Make Sense?

When you have a high-interest debt, it could be beneficial to cash out a portion of your 401k to pay off the debt. However, you need to ensure that you have calculated the interest costs against the penalties you would be paying before you decide to withdraw money from your 401k.

Using a 401k Loan To Pay Off Debt

If you are not eligible for hardship distributions from a 401k and don’t want to pay tax penalties, you can take a loan against your 401k. These loans:

carry a lower interest rate than other alternative options
do not impact your credit score and
are not taxed

You may have to pay an origination fee, but that’s likely lower than the tax penalties you would be paying for early withdrawal. However, there are some restrictions to a 401k loan.

You can’t withdraw all you have in the retirement account. The maximum you can borrow is 50% or $50,000, whichever is less.
You may have to repay the 401k loans within five years. Your spouse’s consent may be taken into consideration before approving the loan.
You can take multiple loans, but the total amount shouldn’t exceed the limit.
Until you repay the loan, your employer may cease contributing to the plan. So, when you repay, you are not actually adding to your total balance.
If you are no longer with your employer, the IRS may want you to repay the remaining loan amount within 60 or 90 days. If you fail to repay it in time, the amount is considered a taxable distribution. So, you may have to pay taxes and a 10% early withdrawal penalty.

The Takeaway

Using your 401k, you can wipe out your debt. And that’s not a bad thing. But it has consequences: delayed retirement and tax penalties. And you are putting your financial health at risk. So, evaluate your options wisely and understand the consequences of your decision before you decide.

About the Author

Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last 10 years has turned his focus to self-directed accounts and alternative investments. Rick regularly posts helpful tips and articles on his blog at SD Retirement as well as Business.com, SAP, MoneyForLunch, BiggerPockets, SocialMediaToday, and NuWireInvestor.