Oct 8, 2024
If you're considering taking cash from your 401(k) to cope with maxed-out credit cards, you may want to think twice. You could owe a ton of taxes, jeopardize your retirement, and not necessarily fix your debt problem.
When you're deep in debt, you're most likely looking for any type of lifeline available. Financial experts recommend getting rid of expensive debt before putting money aside for retirement, because it's rare for your investment returns to be higher than the interest you are paying on the loan.
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Your 401(k) may seem like the perfect pot of money to come to the rescue. However, before you jump into borrowing from your 401(k) or making a withdrawal, you must think seriously about the downsides. That's because the disadvantages could be worse than you think.
Here's what you need to know about the consequences of raiding your 401(k), along with some alternative suggestions about what to do with your debt.
Accessing money in your 401(k) could come at a huge cost
Taking money out of a 401(k) to pay off your debt could end up costing you much more than you imagine.
If you must access your funds, a 401(k) loan is typically the best way to do it since you'll simply borrow money and pay it back with interest that goes into your account. You're not removing the money forever and will typically have to pay it back in five years. You can avoid early withdrawal penalties with this approach. The problem is, the maximum you can borrow is the lesser of $50,000 or 50% of your vested account balance. That won't be enough to deal with $97,000 in debt.
If you borrow and lose your job or want to leave it, you'll also have to repay the loan before the tax due date for the year. If you can't, it's treated as a withdrawal. That's a pretty big risk to take unless your job is 100% secure and you know you aren't going anywhere.
If you can't or don't want to borrow, a withdrawal is an even bigger financial disaster. You'll be taxed on the funds as ordinary income plus owe a 10% penalty so you'll lose a huge portion of what you take out. You'll also lose any future returns. If you withdraw $97,000 15 years before retirement, your account balance will be $267,626.06 lower than it would've been if you left your account alone (assuming a 7% average annual return).
You need money to live on as a retiree once you can no longer work, so robbing from your future self is a very bad idea — especially since 401(k) accounts are protected in case of bankruptcy.
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You'll be taking money you could have kept safe for your future and sending it to creditors — which may not even solve your debt problems unless you bring your balance down to $0 and are confident you won't go back into debt again once you do.
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Try these alternatives for coping with your credit card debt
Now, it's understandable to consider tapping your 401(k) to deal with your credit card debt if you feel like you're drowning.
Maxed-out cards damage your credit score, as can late payments or defaulting. Since your score affects your ability to borrow money, and impacts other things like the cost of insurance, doing damage to it isn't ideal.
If you have a reliable place to live where you can stay put and you won't need to do any major borrowing for a while, it may be worth the hit of filing for bankruptcy or negotiating to settle your debt for less — which many creditors are willing to do if you're behind on payments and they think you'll default.
Bankruptcy stays on your credit record for seven to 10 years depending whether you file for Chapter 7 or Chapter 13. However, you can work on rebuilding your credit right away by getting a secured card and using it wisely. Having bad credit for a few years may be well worth the price of preserving your 401(k) and not struggling for decades to pay off almost $100,000 in debt.
Of course, if you have a high income and could buckle down and pay off that debt in a reasonable time, doing that would be the best option. You could even look into paying off your debt with a personal loan that might have a lower interest rate than your cards to make the process easier.
If that's not feasible, though, exploring debt relief solutions like bankruptcy or debt settlement is likely going to be your best bet — and far better than risking being broke or in debt as a retiree.
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Christy Bieber has 15 years of experience as a personal finance and legal writer. She has written for many publications including Forbes, Kilplinger, CNN, WSJ, Credit Karma, Insurify and more.
