Can You Use a 401(k) to Consolidate Debt?
You have two methods to use your 401(k) for debt relief: early withdrawals and 401(k) loans.
Early withdrawals
You can take early withdrawals from your 401(k) to pay off debt. Technically, this isn’t debt consolidation because you’re just reducing your debts or eliminating them completely. But if you go this route, you may want to take the money you save by eliminating debt payments and use it to supercharge your retirement savings.
The biggest advantage is that you can eliminate some, or all, of your debt in one fell swoop without paying interest. But there is a major downside: if you’re under 59½ years old, withdrawals are subject to income tax and an additional 10% early withdrawal penalty.
“A withdrawal is a taxable event, so you do not pay back the balance, but it is reported on your taxes. The hardship withdrawal is subject to interest and penalties. There is a 10% penalty, unless you qualify for an exception,” says Ashley Morgan, debt and bankruptcy attorney at Ashley F Morgan Law, PC.
Hardship withdrawal
Hardship withdrawals allow you to take early withdrawals from your 401(k) and avoid the 10% penalty (but you still owe income tax). You can withdraw your own contributions and employer matches, but not earnings. Hardship withdrawals are only allowed for very specific reasons, which may include:
Medical expenses for yourself, your spouse, dependents, or plan beneficiaries
Funeral expenses for yourself, your spouse, dependents, or plan beneficiaries
Tuition and related educational expenses for yourself, your spouse, dependents, or plan beneficiaries
Certain home-related expenses, such as costs related to buying a home or repairing damage to your home
Expenses incurred when you live in a federally designated disaster zone
Your 401(k) plan must allow hardship withdrawals, and will determine the specific criteria that qualifies as a hardship. You can only take out enough money to meet your specific financial need.
401(k) loans
If your plan administrator offers 401(k) loans, you can borrow the funds from your retirement account then pay yourself back, with interest, over a period that usually lasts up to five years. You can borrow up to 50% of your vested account balance or $50,000, whichever is less.
“An exception to this limit is if 50% of the vested account balance is less than $10,000: in such a case, the participant may borrow up to $10,000,” says Morgan.
Interest rates are typically low, and all loan payments, including interest, go back into your retirement account. There is no credit check required, so you don’t need to worry about your loan application getting denied because of your credit score.
Should You Use a 401(k) to Pay Off Debt?
Generally, it’s not a good idea to reduce your retirement savings, especially if you have other options. But in some cases – such as when you urgently need debt relief but you’re confident that you can pay back your withdrawals – it can make sense.
Pros of using a 401(k) to pay off debt
Fast debt payoff. You can quickly use the funds from your 401(k) to pay down your debt or pay it off in total, saving you money in the long run by eliminating future interest.
Low interest rates. 401(k) loans often have interest rates lower than other types of debt, and the interest you pay goes back into your account.
No additional debt. When you use your own retirement funds to pay off debt, you don’t have to take on additional debt – such as a personal loan or credit card balance – to consolidate your other debts.
Easy qualification. 401(k) loans generally don’t require credit checks, so you shouldn’t have trouble qualifying for a loan.
Cons of using a 401(k) to pay off debt
Diminished earning potential. When you tap into your 401(k), you reduce your principal investment, which means you have less money generating future earnings.
Delayed retirement. With less money in your retirement fund, you may need to settle for a lower income in retirement or push back your retirement date.
Job termination. If you quit your job or your position is terminated, you may be required to repay your 401(k) loan in full, or risk using your remaining balance to pay off the loan.
Costs and penalties. Early withdrawals are subject to income tax and penalties when you’re under 59½ years old. 401(k) loans have interest and may include a loan origination fee or administration fee.
“If you default on your loan, either by missing a payment or leaving your job and not paying the full loan back within the required time, then the loan converts to a withdrawal. If you leave your job, you only have a short period of time to pay off the full amount. After your default, you are then subject to the interest and penalties,” says Morgan.
Alternatives to Using a 401(k) to Pay Off Debt?
There are many alternatives to using a 401(k) to pay off your debt, including:
Personal Loans
Banks, credit unions, and lenders offer personal loans that can be used to consolidate debt. You take out a loan (ideally with a lower interest rate) to pay off your debts, then pay that single loan back over time. Personal loans have fixed interest rates and fixed monthly payments, making it easier to pay back debt and simplify your debt repayments.
Credit cards
You can consolidate credit card debt by transferring your balances onto a new credit card with a low 0% APR introductory offer. Then you work on paying the balance in full before the introductory period expires – if you don’t, any balance that remains will be subject to the card’s regular interest rate. Introductory periods may last anywhere from six months to well over a year.
The best credit card offers are available to borrowers with good or excellent credit. If you have a subprime credit score, you may not qualify for a balance transfer credit card – though it doesn’t hurt to check.
Home equity loan or home equity line of credit
If you have enough equity in your home, you can use it as collateral to secure a home equity loan or home equity line of credit (HELOC). To borrow against your home equity, you will likely need at least 20% equity in your home’s value.
When it comes to using home equity loans to consolidate debt, they provide you a one-time lump sum that you can use to pay off your debts, then make a single fixed monthly payment to the lender. HELOCs provide you a line of credit, with a set credit limit, that you can borrow against to pay off your debts, then pay back with a variable monthly payment.
But using your home equity comes with greater risks than tapping your 401(k). If you default on your home equity loan or HELOC, you risk losing your home to foreclosure.
Debt settlement services
Debt settlement companies, some of which provide debt consolidation loans, can help negotiate lower payoff amounts with your creditors. If you accept a settlement offer, the company will take a fee and pay your creditors directly using funds that you pay into an escrow account. But fees can range up to 25% of the enrolled debt, and debt settlement services can negatively impact your credit.
Debt management plan
Credit counseling agencies can help you arrange a debt management plan, negotiating lower interest rates or reduced monthly payments with your creditors. Then you sign up for a repayment plan that lasts three to five years, with the agency handling your payments.
Frequently Asked Questions
Is it smart to use a 401k to pay off debt?
Using your 401(k) to pay off debt can be a smart decision, especially if you’re struggling with high interest debt and you’re confident you can replenish your 401(k) over time. But there are financial consequences, so make sure you consider your other options first.
What Qualifies as a Hardship Withdrawal From a 401(k)?
If your plan allows it, you can take hardship withdrawals from your 401(k) to address an immediate and heavy need – such as medical expenses, tuition, funeral expenses, and certain home-related expenses. The IRS and your plan administrator dictate what qualifies as a hardship.
How Do I Avoid a 20% Tax on my 401k Withdrawal?
There is little you can do to avoid owing taxes on an early 401(k) withdrawal. If you want to avoid owing income tax, consider options such as a personal loan, credit card, or home equity loan.
