Is Using My 401(k) to Consolidate Debt a Good Idea?
- A 401k loan is one way to consolidate credit card debt
- 401k withdrawals are subject to penalty and taxes
- Review your alternatives before taking out a 401k loan
Is it smart to use your 401(k) account to consolidate credit card debt?
Credit card debt grows quickly for a number of reasons. You could use your credit cards to pay for an emergency expense, cover your regular living expenses after a job loss, or have spent more than you can afford to pay for over a period of time.
Whatever the cause of the debt, when you decide to address the problem to get out off debt, it makes sense to look at your own resources to see if you can solve the problem using them to consolidate your debt.
You may have a 401(k) account or other retirement accounts, like a 403B or IRA. When you put money in your retirement account you did it to build enough wealth to support the life you want to lead when you retire. You chose to reduce your take home pay by contributing to your retirement account. Changing course to use your retirement funds to consolidate high interest credit card debt should be done carefully, if at all. To make an informed decision, you need to understand how the process works for accessing your 401(k) and what alternatives you have for paying off the credit card debt.
Retirement Fund- How can I use a 401(k) to Consolidate Debt?
Just because you have money in your 401(k) doesn’t mean that you can use it. Check with your plan administrator to find out the rules and restrictions for accessing the funds in your account.
Company Contributions Excluded
Only the money that you contribute can be accessed, not money contributed by your employer.
401(k) Withdrawal to Consolidate Credit Card Debt: Penalties and Hardship Withdrawal
One way you may be able to get money is to withdraw a lump sum. Some 40(k) plans don’t allow any withdrawals, but that is uncommon. Some plans restrict withdrawals to what the IRS defines as hardship reasons (school tuition or fees, buying a home, stopping an eviction or foreclosure, a necessary home repair, and necessary medical care). Paying off credit card debt doesn’t fit the IRS hardship definition, but some plans do allow a hardship withdrawal for paying off debt. The only way to find out if yours permits it is to ask the plan administrator.
Even if you are able to take a hardship withdrawal you will pay a 10% penalty for early withdrawal, unless you are 591/2. The amount you withdraw is counted as income for the year in which the withdrawal takes place and is subject to taxes. If large enough, the extra income could push you into a higher tax bracket. With taxes and penalties figure on losing 30% of what you withdraw.
It is up to you to determine if the benefit of paying off the debt is greater than the cost of the taxes, penalty, and the loss of money that would be building up in your 40(k). Credit cards can have interest as high as 30%, so it is possible for a withdrawal to be a smart choice.
401(k) Loan to Consolidate Credit Card Debt - Pros and Cons
Another option is to take out a loan from your 401(k). Again, you need to find out from the plan administrator if your plan allows 401(k) loans. If permitted, before you make a decision, consider the pros and cons of a 401(k) loan.
401(k) Loan Pros:
- Low interest rate- The rate is the prime interest rate +1%, which is probably much lower than the rate you pay on your credit cards.
- Improve your credit score- Paying off the credit card debt, you will improve your credit utilization (the percentage your balances on your cards use of the credit limits you have on your account). This accounts for 30% of your score, so a big boost in your FICO score is possible.
- Not based on your credit- A 401(k) loan doesn’t use your credit score to determine your eligibility and rate. That means you can borrow from your 401(k) even if your credit is not strong enough to get a personal loan.
401(k) Loan Cons
- Default- If you don’t make the required payments, the loan is treated as a withdrawal, subject to 10% penalty and taxes.
- Risk- If you leave your job while the loan is in repayment, you have 60 days to pay it in full or the remaining balance is treated as a withdrawal
- Lost retirement income- The loan diverts money that you planned on building up. Additionally, some plans don’t allow contributions to your account until the loan is repaid, which will slow down your .
Alternatives to 401K Loans to Consolidate Credit Card Debt
Before you decide on using your 401(k) to consolidate your credit card debt, you should weigh the following alternatives.
- Unsecured personal loan- To get a good rate you need excellent credit. If you are unsure of your credit score, you can go through a pre-qualification with many firms using a soft pull of your credit that doesn’t harm your score.
- Use equity in your home- If you are a homeowner with equity, look at a Home Equity Line of Credit (HELOC).
- Debt Management Plan- See if a Consumer Credit Counseling Service’s Debt Management Plan can lower your interest rate and get you out of debt in 4-5 years at an affordable payment.
Debt Settlement- If you can't afford the payment for the other solutions and the concerns about 401(k) make it too risky for you, look at a debt settlement program to help you get out of debt.
Debt Navigator- The Bills.com Debt Navigator is a free tool that recommends a debt solution based on priorities and goals you provide. There is no effect on your credit from using the tool, which you can find below.
Plan for the Future to Avoid Debt Reoccurring
As you decide what option is best for you, remember that there are two parts of the equation. Comparing the various solutions for getting out of debt is one. The other part is understanding that you won’t solve the problem if you repeat the behavior that got you into debt. Take the time to understand what happened. Make a budget and establish a financial plan to avoid future problems.