The purpose of a 401(k) plan is to set aside money for retirement, but if you have debts with high interest rates, you may be tempted to withdraw funds early to pay off the debt. Withdrawing money from a 401(k) to pay off debt is generally considered unwise because early withdrawals are subject to a tax penalty. Reducing contributions or taking a 401(k) loan to pay debt may be preferable to withdrawing funds.
401(k) Withdrawal Basics
Money you contribute to a 401(k) plan comes directly out of your paycheck before you pay income tax. Since the money in your account has never been subject to income tax, you have to pay income tax on funds you withdraw. In addition, you have to pay a 10 percent early withdrawal penalty if you make a withdrawal before the age of 59 1/2. Withdrawing money from a 401(k) to pay debt, even high-interest debt like credit card debt, is usually a bad idea because you face high taxes and you forfeit the tax-deferred investment growth you could gain if you kept the money in your account.
Debt During Retirement
Withdrawals from a 401(k) to pay debt are more likely to make financial sense after you pass age 59 1/2. After you reach age 59 1/2, you don't face the 10 percent early withdrawal penalty and you may face a lower income tax rate during retirement than you did during your career. Withdrawing funds to pay debt, even during retirement, is not wise unless the debt has a high interest rate. For instance, it wouldn't be a good idea to withdraw money from a 401(k) after 59 1/2 to pay off a mortgage with a 4 percent rate, since the investments in your 401(k) are likely to make at least 4 percent a year.
Withdrawing money from a 401(k) before retirement age is almost always a bad idea because 401(k) loans tend to be a better deal. Some 401(k) plans let you borrow 50 percent of your balance up to a maximum of $50,000 that you have to pay back with interest. A 401(k) loan lets you avoid the 10 percent early withdrawal penalty and income taxes. While you have to pay interest on a 401(k) loan, interest rates tend to be low and payments go back into your 401(k), so you essentially pay interest to yourself. On the other hand, borrowing money from a 401(k) reduces your potential investment returns and may disqualify you from making more contributions to your account until you pay back the loan, so it is generally only a good idea to take a 401(k) loan to pay off high-interest debt after you have exhausted other options.
Reducing your 401(k) contributions is a way to avoid raiding your account through withdrawals or loans, while gaining access to extra cash each month to pay off your debt. In general, you should only consider reducing contributions if you have high-interest debt and can't come up with extra cash to pay down debt through strict budgeting. If your employer offers contribution matching, it is wise to contribute at least enough to take full advantage of the match.
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