Financial experts generally agree it is best not to touch your 401(k) until you are in your retirement years. But there can be times when it is tempting to dip in to those savings to address financial issues you face in the present. The decision should be carefully considered, and it is critical you understand the ramifications. That said, there can be times when it makes sense. FOX Money explains:
Understanding your 401(k) and possible penalties
Drawing money from your 401(k) can come at a cost, which will vary depending on your age and the way you take the funds.
If you’re under age 59 ½ and make a hardship withdrawal, you’ll pay a 10 percent penalty for getting a hold of those funds early, plus income taxes; the withdrawn amount counts as income and may even boost your tax rate. If you’re at least 59 ½, you’ll avoid the early-withdrawal penalty but will owe regular income taxes on the withdrawal.
A more reasonable choice may be a 401(k) loan, which carries a relatively low-interest rate. With this option, you repay your own retirement account over time and avoid the early-withdrawal penalty and income taxes. The only drawback, assuming you stay at your job, is the missed chance for your money to grow with the market.
Should You Lower 401(k) Contributions to Pay Off Debt?
You can borrow up to half your 401(k) balance, but no more than $50,000. A word of caution: If you leave your job before you’ve repaid a 401(k) loan, your company is likely to treat the balance as a withdrawal, which means you’d face income taxes and the potential penalty.
Also, as financial guru Suze Orman noted, you’ll be taxed twice on the money used to repay your 401(k) loan – once when you earn it, and again when you withdraw it years later in retirement.
Given those caveats and the need to carefully consider the ramifications, here are some reasons you might turn to your 401(k) to pay off debt years or decades before retirement.
You’re struggling with high-interest debt
If you’re carrying balances on credit cards with oppressive interest rates, you could come out ahead by taking a low-interest 401(k) loan. Imagine trading a credit card balance with a 16 percent interest rate for a 6 percent interest rate 401(k) loan.
A heavy debt burden poses a risk to your financial security. In fact, financial expert Dave Ramsey recommended eliminating debt before saving for retirement, even if it means sacrificing a company 401(k) match for a year or two.
You’re buying a home
Many younger workers scoop into their retirement accounts to come up with a down payment on a house. If homeownership is a priority and you don’t have access to another sizable chunk of funds, a 401(k) loan may be a reasonable option.
You encounter an emergency
If you suddenly faced a costly medical emergency or another urgent situation that might plunge you into new or greater debt, 401(k) funds could save the day.
You’re desperate to avoid bankruptcy
Using your 401(k) to pay off debt to avoid bankruptcy may not be the wisest move, given that U.S. bankruptcy courts generally shield retirement accounts. You might decide to go this route anyway for professional or personal reasons. It’s worth consulting with a financial professional or lawyer.
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As with most major financial decisions, there are benefits and disadvantages to borrowing from your 401(k). Make sure you have discussed these with a financial advisor before you make the move, as it is not reversible.