Using Your 401(k) to Pay Off Debt? How It Works

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For years you’ve slowly built your retirement fund so one day you can retire somewhere warm and sunny. Plus, you need to finance all those piña coladas you’ll be sipping in between rounds of golf. You have big dreams, which is why you know you shouldn’t touch the money in a 401(k) before you’re ready to retire.

When financial hardship hits, however, you may be able to use the money in your 401(k) to help you pay off debt. You usually have the option to pull money out of your 401(k) or take out a 401(k) loan. But what are the real costs of doing this? Here’s what to consider before touching your nest egg.

A warning against using your 401(k) to repay debt

Just because you can take out money from your 401(k) to help repay debt, doesn’t mean you should. It’s something Bruce McClary, vice president of communications at the National Foundation for Credit Counseling (NFCC) in Washington D.C., warned against unless it’s absolutely necessary.

“I advise people never to borrow against their 401(k) unless it’s for something really serious like avoiding foreclosure or a life or death emergency,” said McClary. “Because what you’re doing when you borrow from your 401(k) is first of all, you’re subjecting yourself to additional costs that are associated with a repayment like the interest rates or fees,” he noted, adding that you’d also miss out on any growth those funds may have seen if you hadn’t withdrawn them.

But if push comes to shove and you don’t have any viable alternatives, here’s what you should know about making a withdrawal from your retirement fund.

Withdrawing money from your 401(k)

If you want to withdraw money from your 401(k) to help pay off a debt, this is what you need to know.

How it works

If you have a 401(k), you may be able to withdraw money early from it. Although ideally, you won’t withdraw money until the minimum age to qualify for retirement at 59½. Your employer will have a set process for how to pursue 401(k) withdrawals. This is particularly important if you’re hoping to qualify for a hardship withdrawal, as employers can set their own considerations for what qualifies as a hardship.

Consider the following as you make a withdrawal:

  • Withdrawal limits: Withdrawal limits vary as plans may set their own limits for the amounts participants can borrow. “If you’re thinking about going and borrowing $100,000 for some kind of emergency, you’re kind of out of luck because you’re capped out there for the amount that you can borrow,” said McClary.
  • Tax fees: Before the age of 59½, taking out money from your 401(k) is considered an early deduction. You may have to make an extra 10% tax on any distributions made. The tax is applied to the amount you receive and you must include it in your income.
  • File Form 5329: If you’re looking to do an early withdrawal you may have to file the IRS’s Form 5329.

Risks in making a withdrawal

  • Additional tax: The additional 10% tax previously mentioned is a cost you need to plan for.
  • Income adjustment: Because the money you receive from an early 401(K) deduction is considered income, you may be placed in a higher tax bracket. One of the benefits of putting your money in a 401(k) is that when you take the money out while in retirement, you’re generally living on a lower income then when you were working.
  • Long term losses: You may lose some of the benefits of tax-advantaged interest compounding; this could reduce your retirement savings.
  • No repayment options: Unlike a 401(k) loan, you can't repay hardship withdrawals.
  • Pause on retirement contributions: Your employer may not allow you to make 401(k) contributions while you have an outstanding loan balance.

Making a hardship withdrawal

Accessing the funds in your 401(k) may be your only option when you’re strapped for cash and don’t qualify for credit or are faced with an emergency. Although a withdrawal can come with an extra tax on distributions, that isn’t always the case.

Under certain circumstances you may qualify for a penalty-free withdrawal: for example, if you need to pay unreimbursed medical bills greater than a certain percentage of your adjusted income. In addition, a special hardship withdrawal can be used to support you during emergencies related to natural disasters, home repairs, education costs, medical expenses and more.

Taking out a 401(k) loan

If you’re considering taking out a 401(k) loan to pay off debt, you should familiarize yourself with the borrowing limits, interest rates, fees, and terms associated with paying off your loan.

How it works

If you’re looking to take out a 401(k) loan, look no further than your H.R. department, benefits department, or plan provider. The ability to take out a loan, and the terms for a 401(k) loan, are usually outlined in your plan documents. Once you fill out the appropriate paperwork, you can generally expect to receive the money within a few days.

Your loan payments are not plan contributions. McClary warned against taking on a 401(k) loan if you aren’t prepared to meet your repayment terms. ”Once you set that plan in place you can’t make any adjustments to it. If you find out you’re going to need more time to repay it or if you try to buy yourself some time, that just doesn’t work,” McClary said. He noted that your plan administrator can help you establish the repayment schedule.

Here are more details on a 401(k) loan.

  • Borrowing limits: 401(k) loans cannot exceed either the greater of $10,000 (or 50% of your vested account balance) or $50,000. Whichever amount is less, is the borrowing limit.
  • Repayment term: The specific plan you are loaning money from provides your loan terms and the procedure for applying for a loan. As well as the repayment terms for the loan. However, repayment of the loan must occur within five years according to the IRS and payment must be made in somewhat equal installments that include both the principal and interest that are paid quarterly.
  • Interest rates and fees: When you sign a loan agreement, it will outline the terms of your loan, like the interest rate and any fees that will apply. That being said, the typical interest rate paid back on 401(k) loans is the current prime rate plus 1%.
  • Taxes: 401(k) loans do not qualify as taxable distributions unless you fail to satisfy the plan loan rules relating to the amount, duration, and repayment terms. If a loan is not paid back according to the repayment terms, then it is treated as a distribution from the plan and is considered taxable income.

Risks in borrowing against your 401(k)

If you remove funds that were intended for retirement savings, you risk stunting your progress on earning compound interest and at the same time are losing the advantages associated with saving funds in a 401(k).

“There’s a very significant cost to taking an early withdrawal from your 401(k),” said McClary. “And there is also that setback that you’re delivering to yourself by pulling that money out early, leaving you with less when it's time to retire.”

Here are some other risks that come with a 401(k) loan:

  • High cost of borrowing: A $20,000 loan can cost $11,540 even if repaid on time, based off the assumption you would have earned an 8% rate of return on the 401(k) fund and a 5.75% interest rate on the loan.
  • Penalties: Unpaid loans risk losing earnings and may levy additional taxes; penalties may also occur.
  • Double taxation: You risk double taxation on the loan interest. When you repay your loan, your payments will be made with after-tax dollars. When any distributions are made at a later date, the interest that you paid yourself will then be taxed a second time. “These payments that you’re making as automatic deductions from your payroll are not to be confused with the regular contributions that are going to your 401(k). Those deductions are made with pretax money, your payments towards your loan are made with after tax dollars,” McClary said.
  • Potential acceleration of repayment plan: If you lose or quit the job that your 401(k) plan is administered by, your 401(k) loan payment plan will be accelerated. Before you take out a 401(k) loan, review the plan rules and terms given to you carefully.

Why a 401(k) loan may not be all bad

For all of the risks that come with a 401(k) loan, it also comes with a few benefits. For example, borrowing from your 401(k) is generally a quick process and you’re likely to receive your funds within a few days. McClary noted that convenience is one of the main appeals for some people.

“The convenience of the process, when you go to your benefit administrator and you set in place the steps to borrow for your 401(k), I think one of the things that is more attractive to people and more attractive about this process then going to a bank,” said McClary. “Nobody is going to be checking your credit, so you’re not subject to that kind of scrutiny because essentially you are borrowing from yourself.”

Here are more details on the perks of a 401(k) loan:

  • No credit check: Because you are borrowing from yourself instead of a bank or financial institution, you will not need a credit check or your score and history to apply for a 401(k) loan. This loan will also not impact your credit.
  • Lower interest rates: You may encounter lower interest rates on a 401(k) loan than you would on a credit card or on other loans.
  • No prepayment penalties: You can choose to repay the loan before the five-year period without penalty.
  • No taxes or penalties: As mentioned previously, you should not incur more taxes or face a penalty when taking out a 401(k) loan unless you fail to satisfy the plan loan rules.

Should you use your 401(k) to repay debt?

Now that you’ve seen both the pros and cons of withdrawing money from your 401(k) or taking out a 401(k) loan to pay off debt, you need to think long and hard about what your course of action will be.

In McClary’s opinion, the best course of action is to avoid withdrawing money or taking out a 401(k) loan if possible.

“You don’t want to interrupt any of the progress that you’ve worked so hard to make when saving for retirement,” McClary warned. “The more you can do to keep yourself on track, the better off you’re going to be in the long run. So, a short-term emergency, you should look elsewhere to manage that.”

You may find using a 401(k) loan or withdrawal is the better of two evils if you’re at risk of defaulting on a private student loan debt, owe a large amount of money to the IRS, your credit card interest is extremely high, or are at risk of bankruptcy or foreclosure.

If you have good credit, however, you may be better off with a traditional personal loan than touching your retirement fund. This type of loan doesn’t require collateral and can come with competitive rates depending on your credit score and other factors. You can learn more about personal loans here.

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