With all the uncertainty in the modern economy, anyone can find themselves facing a debt problem. Many people currently having trouble with their debts have been working their whole lives. Frequently, these people have a 401(k) account through their jobs, which is to be used for their retirement. It might be tempting to use the money in your 401(k) to help pay off some or all of your debts, but you should think twice before you take that option.
There is a load of issues and complications when it comes to taking money from your 401(k) early, and understanding the implications of this action will help you make a better decision when it comes to finding a way to resolve your outstanding debts.
An Example of a 401(k) Withdrawal
In order to understand why it’s rarely a good idea to withdraw money from your 401(k) to pay your debts, let’s look at an example of an early withdrawal from a 401(k).
If a worker accumulates $15,000 in credit card and other debt, and they have $25,000 in their 401(k), then it seems like they should easily be able to withdraw the $15,000 they need, leaving $10,000 for their retirement.
However, 401(k) withdrawals are taxed differently than other kinds of income. Specifically, they are taxed at your income tax rate plus an additional 10% penalty. If our worker’s tax rate is 25%, then they will pay 35% of their withdrawal. This means that the $15,000 withdrawal will cost $5,250 to access. The result is that, after the withdrawal goes through, the balance in the 401(k) will be only $4,250.
This isn’t the end of the complications though. The 401(k) for this worker grows at an average annual rate of 8%. If our worker is 35 and has 30 years until retirement, then they miss out on years of excellent growth in the account. For example, if our worker doesn’t withdraw anything from the $25,000 they presently have, but also doesn’t add any more money to the account, the $25,000 will turn into $250,000 by the time they reach 65.
However, if the worker withdraws the $15,000 to pay off debts and pays the $5,250 in taxes on the income, then they’ll have a balance of $4,250. If they let that balance grow until retirement, the final balance will be about $48,000. That means that the actual cost of the early withdrawal will be nearly $205,000, $5,250 in taxes now, and $200,000 in lost growth over the next 30 years.
This example shows how withdrawing money from a 401(k) might seem like an easy solution, but it is short term thinking. Even if the worker in our example takes some short-term hits and losses from their outstanding $15,000, they will still come out ahead in the long term, Moreover, this money is much more valuable as you grow older, because your ability to work and generate an extra income is much reduced compared to when you are younger.
Pros and Cons to 401(k) Early Distribution for Debt Repayment
As the example above demonstrates, there are far more cons than pros when it comes to paying your debt off with a 401(k) withdrawal.
The only real pro to paying your debt off with a withdrawal from your 401(k) is that you can get the money quickly and pay your debts off quickly. Since its money that already belongs to you, then you won’t have to make payments on a loan, nor will you have to go through any application process to acquire the funds.
There are two major cons to withdrawing money from your 401(k) to cover your current debts, the tax penalty and the lost growth over time.
The tax penalty itself should be enough to dissuade people from taking money out of their 401(k). Most people who have a 401(k) are in at least the middle, 25% tax rate for personal income. Paying a tax rate of 35% makes this withdrawal incredibly expensive. If you consider the tax rate to be similar to an interest rate on a loan, in the sense that each reflects how much you’ll pay for access to funds, you can easily see that 35% is an astronomical rate. Most personal loans range from 5%-15%, so a rate of 35% is more than double the cost that you’d pay for an equivalent loan.
The lost growth is the biggest issue. It’s much harder to generate income as you get older because you simply can’t work as hard. Having retirement savings can make the difference between retiring when you want to and living the quality of life you’re used to, or working far beyond when you’d like to retire and taking a downgrade in your standard of living. The lost growth that you’ll experience can prevent you from living out some of your retirement dreams like traveling, helping your children or grandchildren with buying a house or paying for college, or just having the security and peace of mind that you’ll be able to cover your medical costs as you age.
One of the best solutions to debt that still lets you take advantage of your 401(k) is a 401(k) loan. These loans borrow against the value in your 401(k). You can borrow up to 50% of the vested savings into the account, up to a maximum value of $50,000. This is a good idea if you can get the loan at a low interest rate and are using it to pay off high-interest debt like credit cards.
However, it is still usually in your best interest to leave your 401(k) alone. The 401(k) allows you to defer taxes on your income, and let your money grow tax-free. You can begin withdrawing money without a tax penalty from a 401(k) when you are 59 ½. If you’ve retired, then you’ll probably be in a lower income bracket than when you were working. This allows you to pay lower taxes on the money you’ve saved over your working life.
This tactic only works if you don’t withdraw from the 401(k). If you’re having problems with your debt and are considering dipping into your 401(k) to pay them off, we suggest you make an appointment with a debt or credit management company. These organizations can help you understand all of the different implications to your actions, and can help you chart out the best way to get out of debt without hurting your future retirement funds.