Personal Finance Tips: Should I Use My 401(k) To Pay Off Debt?

tax penalties on 401k withdrawal

25% of people between the ages of 24-35 have taken money out of their 401(k) retirement plan to pay down debt – and taking some money from your retirement savings to pay off your debt may seem like a good idea if you’re not sure how else to get out of debt.

But is it really a good idea to use a 401(k) to pay off debt? In this article, we’ll explain everything you need to know.

Never Use Your 401(k) To Pay Off Debt – The Cost Is Just Too High

In almost every case, using your 401(k) to pay off debt is a bad idea. You’re raiding your retirement fund to pay for your immediate expenses – and you may be paying more to do so than you think.

First of all, there is a 10% tax penalty on all early 401(k) withdrawals – and the money is also taxed as ordinary income on your yearly tax returns, which could knock you into a higher tax bracket for the year.

But that’s not the worst part. Raiding your 401(k) could cost you hundreds of thousands of dollars in the long term. Read on to find out how.

You’re Losing Out On Future Returns From Your 401(k), Too

Let’s say you’re 30 years old, and you withdraw $20,000 from your 401(k) to pay off a lot of high-interest debt. How much would that $20,000 be worth in 35 years, when you’d be ready to retire?

Adjusted for inflation, the average yearly return in the US stock market is about 7%, but we’ll use an even more conservative 5% yearly return. How much will it be worth?

The answer is $110,320.31. By withdrawing $20,000 to pay for your debt, you’ve essentially “lost” more than $90,000 in future returns – in addition to the tax penalties you have to pay.

Yes, you can mitigate this by contributing more to your 401(k) in the next few years – but it’s not always easy to do that, and the fact remains that taking money out of your retirement account at any time will harm your future returns.

Taking Money Out Of Your Retirement Accounts Should Always Be Your Last Resort

If you are in debt, don’t start thinking about raiding your nest egg yet. As you can see from the above examples, using a 401(k) to pay your debt down will result in high tax penalties and loss of investment returns.

So unless you have no other choice, do not take early distributions from your 401(k) to get out of debt. Instead, consider other options – like budgeting and paying down debt, reducing your monthly payments with a consolidation loan, or credit counseling. Consider your options, and you’re sure to make the right choice.