Dear reader, Paying off your debts with your 401(k) is not as practical and beneficial as it sounds, especially when you may have other avenues available to manage and eliminate your debt.
If you are younger than 59 ½ when you withdraw money from your 401(k), you will be hit with a 10 % upfront early withdrawal fee and you will have to pay income tax on the amount you withdraw at an ordinary tax rate. If you meet certain requirements, some employers allow people age 55 and older to make penalty-free 401(k) withdrawals, however, you still have to pay taxes. In addition to the fees and taxes you have to pay, you will lose the potential and exponential growth the money could be earning you through the investments in your plan.
So, unless you need the money for a matter of extremely high urgency like stopping a foreclosure or bankruptcy, you should not dip into your retirement plan. A similar option to a withdrawal is a 401(k) loan. Not all companies offer this option, but if they do, you are allowed to take a loan against your account without having to pay an early withdrawal fee. You will have a cap in how much you can borrow and a pre-determined repayment period. Payments are typically deducted from your payroll and you even pay yourself a very low interest on the loan. Yet, this option is not financially beneficial either. Although you pay yourself back with some interest, it is typically around 2%, nothing compared to how much your money could be growing through your 401(k) investments. In addition, you are “tied” to the employer until the loan is paid in full. If your employment ends, voluntarily or involuntarily, the outstanding loan would be due immediately. If you are unable to make the payments, you will default on your loan and be faced with the 10% early withdrawal fee and you will have to pay income tax on the outstanding amount.
An alternative solution worth considering is a debt management program (DMP), a self-administered repayment strategy or even a loan consolidation. But almost as important as finding the right strategy to pay off your debt is understanding and changing the behavior or circumstances that led you to indebtedness. Repaying your debt by getting into a new debt could be a dangerous move if you don’t have a strategy in place to handle it. If you are not sure how or where to start, talk to an NFCC-certified credit counselor. A counselor can help you assess your current financial situation and gain objective insight into your spending behavior. You can counselor can help you create a monthly budget and closely examine your debts and financial responsibilities. Together you will set realistic financial goals and develop a repayment strategy based on the options available to you. Your debt repayment options will depend on your specific situation, like the types of debts that you have, how much you owe, and your current income. The sooner you start working with your counselor or taking care of your debt, the more options you will have and the less costly it will be. Talk to a counselor today and continue planning for the future, continuing your uninterrupted 401(k) contributions. You should focus on growing your investment while finding more cost-effective solutions.