Should I Use My 401(k) To Pay off Credit Card Debt?

What Is a 401(k) Account?

A 401(k) account is a retirement savings account that is sponsored by an employer. Employees agree to contribute a percentage of their paychecks to the account which may either be done in pre-tax or post-tax payments.

There are two types of 401(k) accounts: traditional and Roth.

With a traditional 401(k) account, employee contributions are taken from gross income. This means that the employee’s taxable income for the year is reduced by the amount of contribution. Hence, no taxes will be collected until the employee does a withdrawal from the account.

On the other hand, contributions made to a Roth 401(k) are deducted from the employee’s post-tax income. Hence, no taxes will be collected when the employee makes a withdrawal from the account.

Rules in Withdrawing Funds From a 401(k) Account

Generally, withdrawals can be made from a 401(k) account given the plan owner meets any of the following conditions:

Reaching the Age of 59 1/2

If a withdrawal is done before this age, a 10% early withdrawal penalty will be collected. Also, early withdrawals will be subject to income tax at the plan owner’s regular income tax rate.

Plan Owner Becomes Disabled

If a plan owner becomes disabled, defined as rendering the plan owner incapable of self-sustaining employment with loss of income, then withdrawals may be allowed even if the plan owner has not reached 59 ½. However, any withdrawal made will still incur the penalty and taxes on an early withdrawal.

Plan Owner Is Withdrawn From the Workforce

If a plan owner is terminated from an employer, then withdrawals will be allowed. However, if the plan owner was employed full-time for at least 5 of the last 10 years by that company (or any company who provided the 401(k) account), then taxes and penalties on early withdrawal may be waived. Note though that this rule does not apply to self-employed individuals.

Plan Owner Dies

If the plan owner dies, then the beneficiaries will be able to make a withdrawal from the account. The beneficiary must provide a death certificate to the plan administrator in order to initiate the process.

Employer Terminates the Plan and Does Not Replace It With Another Plan

If an employer decides to terminate the 401(k) account and does not offer a replacement plan, then plan owners will be allowed to withdraw their funds.

Reason for Withdrawal Is Financial Hardship

What may count as financial hardship are cases when the employee has to pay for medical expenses for himself, for a spouse, or children; buys a house; pays school expenses; pays for property to avoid foreclosure or eviction; or pays for funeral expenses.

Things to Consider When Withdrawing From a 401(k) Account

If you are considering withdrawing funds from your 401(k) account in order to pay off some debts, here are some things to consider:

Lower Interest Rate

The interest rate from a borrowed 401(k) account will be lower than when you borrow from a bank. Although there may be fees associated with the borrowing, they are still likely to be lesser compared to the early withdrawal fees.

Limits in Borrowing

You are allowed to borrow up to half of your vested account balance or $50,000, whichever is lower. The same limit applies if you engage in multiple borrowings from the 401(k) account.

Short Repayment Term

The repayment term for a 401(k) loan is usually 5 years unless the loan is used for a house purchase which comes with a longer repayment term.

No Credit Check

When you borrow from your 401(k) account, you are not subjected to a credit check. This may be beneficial if you have a low credit score.

Suspension of Contributions

Your employer has the option to temporarily suspend making contributions to the plan until repayment has been completed. This means that you will lose the chance of growing your nest egg after borrowing from it.

Should I Withdraw From My 401(k) Account to Pay Debts?

Before you decide to withdraw from your 401(k) account, you should be aware of the benefits and drawbacks associated with it.

It is important to make a comprehensive comparison especially in terms of interest rate on the debt and penalties following the withdrawal.

Should you opt for the 401(k) loan, make sure this is advantageous compared to the bank loan. Also, it matters to have a good financial plan in place so that you can efficiently pay off the debts and simultaneously contribute to your retirement account.

In most cases, it is wiser to not withdraw from your 401(k). Instead, you must seek a more advantageous alternative such as a personal loan or credit card debt consolidation.

You should try to look for other options before resorting to the 401(k) account since these loans have penalties and risks associated with them. This will go a long way in ensuring that you do not incur financial hardships later on due to these withdrawals.

Final Thoughts

Using your 401(k) to pay off debts has its own advantages and disadvantages. Before you take any action, be sure to weigh these pros and cons carefully so you can make the best decision for your financial situation.

Always take into consideration the interest rates, penalties, taxes, and other associated costs before making a decision. If you are unsure what to do, it is best to speak with a financial advisor for more guidance.

Some other options you can take are personal loans, credit card debt consolidation, and home equity loans. However, each of these options has its own risks and benefits so be sure to do your research before deciding on which one is best for you.
401(k) funds can be used for emergencies but it's important to note that there are penalties associated with early withdrawals. It's usually best to try and find other ways to come up with the money needed for emergencies instead of withdrawing from your retirement savings.
The interest rate for a 401(k) loan is lower because the funds are coming from the account itself. When you borrow from a bank, you are borrowing money that has been set aside to be used for loans. This means that the bank has to charge a higher interest rate to make a profit. 401(k) funds are not as readily available as money from a bank so this is why the interest rate is lower.
Yes, your employer can suspend contributions to your 401(k) plan if you take out a loan. This means that you will miss out on the opportunity to grow your nest egg while you are repaying the loan.
Your financial advisor will help you weigh the pros and cons to determine if a 401(k) loan is best for you. They can also guide the process so that you know what to expect.

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

Allow us to help you prepare and plan for your retirement ahead. Contact a financial advisor in St Helena, CA or visit our financial advisor page for other details.

401(k) Plan FAQs

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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