Should you tap your 401k to pay off debt?

401k to pay off debt

Tapping into your 401k to pay off debt

Taking out money of your 401k today to pay off your debts can be healing, but you may regret taking such a step later in life. Tapping your retirement account today will eventually bring down your retirement savings and may force you to work longer.

Apart from the damages done to your retirement savings, tapping your 401k also reduces the tax benefits that you are eligible to get. While some financial experts suggest trying other alternatives in the beginning (lifestyle changes, spending cuts, and raising income), some advise to manipulate 401k to pay off debt first. But should you really cash out 401k to pay off debt? See what your priority should be if your debt levels are overwhelming.

If it’s is a real emergency, and there is no way out, it seems logical to tap into your 401k plan to pay off your debts. If you are living beyond your means and then paying off your creditors using the funds of your retirement account, you are simply paying your way out of a secure retirement.

According to the Employee Benefit Research Institute (EBRI), more than half of all retirement plans allow employees to take out loans from the accounts. This is beneficial as it allows the account holders to tuck in more retirement funds and have the flexibility to able to access it during emergency.

However, you should not be a frequent visitor of your 401k until retirement. Never make use of it as a safety net. You can set up other emergency savings, which you can use without paying any penalties.

According to a report by EBRI, individuals within the age 30-59 years are more likely to tap their 401k than individuals of any other age group.

Retirement may seem like a distant dream to many young individuals out there. But you need to remember that once you retire, you would live off on what you’ve saved during the past few decades, and you definitely wouldn’t want to again start working at 65. We all know that Social Security is there to help you survive after retirement. But would it suffice to sustain the lifestyle you led for the last 40 years?

Tapping your 401k to pay off debt can have a huge effect

Taking out a loan from your 401k account can have a drastic effect on your retirement balance if you don’t contribute to your account while paying back the loan at the same time.

Check out this real life example. Alan Nagler, a Nutritionist in Michigan, was forced to get a part-time job at the age of 70 just to make up for the $100 shortfall in his monthly income. He had nothing to do but to assume an employment to survive at the age of 70.

So if you have no option left but to tap your retirement account, make sure you pay off the loan as soon a possible and continue to make payments towards the plan apart from the loan repayment.

Another thing that most borrower overlook is that you’ll be taxed twice on the loan amount. First the loan repayments are made with after-tax income. Second, you’re taxed when you withdraw the money at retirement.

Taking an early distribution could be heart-wrenching! However, if you haven’t changed your job yet, you can take an early distribution in a hardship case. If you want to borrow $10,000, you’d actually have to withdraw $20,000 since you’ll be paying 50% in taxes and early withdrawal penalties. This might mean starting over with your 401k and further reductions in the balance at retirement.

Article Contributed By Andy Masaki