Debt can be an overwhelming burden that leaves many people struggling to find a way to relieve themselves from the stress. One option that is often posed is to stop contributing to your 401k for the purposes of paying off debt. Even further, some consider withdrawing from their 401K accounts to pay off their debt. However, this course of action is complicated, and deciding if this is the best option for you requires some consideration. Here are the key things to consider before stopping your 401F contributions or withdrawing from your account.
What is your 401k company policy?
This is an important consideration because if your company matches your 401k contributions then there is an incentive to continue contributing. This is basically free money from your company and it’s not uncommon for companies to match up to 6% meaning that you should do what you can to make the most out of your company’s contributions. How it works is that, for some companies, for every $1 you put towards your 401k, the company will pay an additional $0.50 to a point. Once you’re putting 6% of your annual salary towards your 401k then every additional dollar is on you. This is a great opportunity to make significant contributions to your 401k so check with your employer and see what kind of contribution incentives are provided if any. If there are no incentives, then stopping your 401k contribution to pay off debt might be an option for you.
What kind of debt do you have?
The kind of debt you have really matters when it comes to tackling the problem. Student loan debt? Mortgage debt? Credit card debt? Medical debt? A combination of them? When it comes to paying down debt you’ll want to tackle the debt with the highest interest first. The interest rate matters a lot because that’s how you determine what to prioritize. My suggestion is to isolate what subset of debt you have that you can pay off and strategize a game plan to tackle the subset. However, if you’re barely making minimum payments on your debt, this can be tricky. You need to calculate how much money you need to target towards debt, and for how long, before even considering stopping 401k contributions.
You may even consider lowering how much you put towards your 401K before stopping altogether. For example, if you are putting away 6% of your annual income towards your 401K, consider lowering that to 3% and using the difference to tackle down debt. Even if you’re only contributing 1% of your salary to your 401K that can help make a difference, especially if your employer matches your contributions. Lowering how much your put towards your 401K can help without stopping completely. Once you get your debt situation under control, then you can reevaluate and put more money into your 401K.
What are your long-term debt goals?
It’s important to evaluate what your debt looks like and consider how you came into debt, to begin with. If your debt is from student loans or a mortgage the good news is that those are considered investments. Unless you plan to go back to school or buy a new home those debts are not going to remain fairly fixed unless, of course, you consider refinancing them. However, debts from personal loans or credit card debts can be indicative of a larger spending problem that can grow over time.
Let’s say you have a credit card that you owe $5,000 on and work hard to pay that off, the only way to guarantee you won’t accumulate that debt again is to get on top of your spending habits. I would strongly encourage you to examine your spending habits before reallocating money from paying into your 401K to pay off your credit card debt. However, student loan debt is just as much of an investment as a 401K and paying down your student loan debt can alleviate your budget enough to put more money back into your 401K once the debt is paid off. When it comes to student loan debt, the investment of your education often increases over time as young professionals advance in their careers and their salary increases as well.
What kind of sacrifices are you willing to make?
Stopping contributions to your 401K to pay off debt should be the last line of defense towards financial freedom. So before you go down that path really consider if there are alternative ways to free up room in your budget. Can you consolidate debt? Can you spend less on your bills? Is there a way to refinance some of your existing debt? I ask you to seriously reflect on your finances because your 401K will matter someday, even if you’re too young to consider retirement now. Where in your life are you willing to put in the financial sacrifice?
Another common question when it comes to debt relief and 401K is whether or not you should withdraw savings from your account to help pay down the debt that you have. Let’s take a closer look at what that might look like.
Using Your 401K to Pay Down Debt
Retirement accounts, like a 401(k) and IRA, are a practice in delayed gratification. Millions of people have chosen to set aside money that they don’t need now in order to enjoy it later on in life. It’s an admirable goal that has many benefits. Life happens though. What if you are faced with a situation NOW, that requires more money than you seem to have? Does it make sense to pull money from an area where it’s not being used to help in an area where it will be used? First, let’s take a quick look at what these 2 retirement funds offer and how they are different.
Understanding 401(k) (Employer-sponsored retirement plan)
- Funded with Pre-tax dollars from your paycheck
- Tax-deferred growth on your investments
- Investment options provided by the employer
- Matching payment plans are often provided by the employer
- Typically accessed after retirement to lower amount of taxes due (Roth 401(k) – Funded with after-tax dollars up to the plan’s contribution limit.)
Understanding IRA (Individual Retirement Account)
- Funded with dollars that can be classified as tax-deductible
- Tax-deferred growth on your investments
- Personally chosen investment options
- Some matching payment plans are available
- Typically accessed after retirement to lower amount of taxes due (Roth IRA – Allows a person to set aside after-tax dollars up to a specified amount each year.)
So why would you want to take money out of your 401(k) or your IRA to pay off debt? Let’s say you owe $20,000 in credit card debt. You look at your account and find a current balance of $30,000. In your head, it makes sense to take $20,000 out of your retirement plan and immediately pay off your debt. The money seems accessible and the plan looks straightforward and quick, but it’s not. Let’s take a look at what will actually happen.
How it Works to Pay Off Debt From a Retirement Account
Here’s the way this scenario generally plays out with a 401(k) or IRA account: In order to access any money from your retirement plan, you must be 59-1/2 years old or there is an early withdrawal penalty. If you want to make an early withdrawal of $20,000, you will be penalized $2,000. You will also be taxed depending on the tax bracket in which your income level places you.
Let’s say you currently make $60,000/year. You will have to pay 22% in income tax when you withdraw your $20,000. (A net income level of $80,000/year places you in the 22% income tax bracket) This means that you will be paying $6,800 (32%) of the $20,000 you withdraw which leaves you with a mere $13,200 to throw at your debt. There are some exemptions where a 10% fee can be waived but generally, you will still end up paying at least 12% in income tax no matter how much money you withdraw early.
Pros and Cons of Paying Off Debt from Your 401k or IRA
So, does this approach make sense? What are the Pros and Cons of accessing your 401(k) or IRA to pay down debt? Here is a look at the good and the bad of pulling these funds:
- Quick access to available funds
- Balance may be replaced quickly if the fund has an employer-sponsored matching payment plan
- Early withdrawal almost always includes a 10% fee
- Income tax adds 12% – 37% fee (see tax brackets )
- Amount of funds gaining compounding interest is reduced
While there are pros and cons to using this method, the disadvantages are too great to recommend it in most situations. So, how do you get a jump on your debt if you can’t make use of your retirement savings? Here are a few better options to consider.
Alternatives for Paying Down Debt from your retirement account
1. Buckle Down and Do a Budget
It would be more efficient to stop putting money into your retirement fund for 1 year and focus that money on debt, rather than withdrawing money early and paying the penalty. You’ll come out ahead if you do the hard work of creating a budget, and start throwing as many available dollars as possible at your debt.
2. Rob your Roth IRA
If you have a Roth IRA that you have been funding for more than 5 years, you should be able to withdraw tax-free funds from that account without penalties. (You’ll only be able to withdraw the principle – not any gains made on your investments) This will slow down your retirement savings, but if it cleans up some credit card loans, it might be worth it.
3. Borrow from Tomorrow
Another possibility is to take out a loan from your 401(k) account at a low-interest rate and use the amount to immediately pay off a debt with a higher interest rate. As you are essentially using your own funds to refinance a loan, you’ll miss the opportunity to generate interest revenue on the withdrawn amount. However, this option might be just the solution for your debt situation. To find a more thorough description of this option, read this article: Paying Interest on a 401k Loan
4. Debt Relief
If you’re up against a pile of debt and are in danger of having to declare bankruptcy or foreclose on your house, then taking funds from your 401(k) or IRA might be your only chance. However, getting professional advice might help you save thousands. You can find more information by reading these articles:
The Ultimate Solution
In any and all of these options, the important factor is whether or not you choose to establish good money habits. A lasting change in finances comes down to a change in mindset. Determine to quit debt and develop a plan to make it happen. Going through the effort to pay down debt is only worth it if you learn from your past. Decide to not repeat the same financial mistakes and you’ll be well on your way to a brighter financial future.
The fact of the matter is that if you can comfortably pay off debts while contributing to your 401K then you should put money towards both. Even if it means that your debts will be paid off at a slower rate, you are still setting aside money towards your retirement and that money will be important later in life. Ultimately this is a decision that only you can make and decide for yourself and any step towards financial freedom and security is helpful in the long run.