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When credit card debt causes problems for your budget, you may consider withdrawing money out of your 401k or IRA. If you have money sitting in a retirement account, it can be tempting to use it to overcome your challenges with debt. But how much will that delay your retirement and is it worth the penalties you’ll typically face?

[On-screen text] Should I use my 401k to pay off credit card debt? With Steve Rhode, The Get Out of Debt Guy

Steve Rhode, The Get Out of Debt Guy: Is it a bad idea to use a 401k or IRA hardship withdrawal to pay off credit card debt?

Taking money out of your 401k or IRA may make sense for some and not for others. Mathematically, most people miss the true cost of a retirement account withdrawal and think that the only cost is the low interest rate they may pay on the borrowed money.

Money taken out of a retirement account that has a 5 percent interest rate really costs 15 percent when the stock market is doing well and making a good return. You see, you miss out on the return you would have earned if the money had been left in the account.

Additionally, you’re losing the compound return the money would have earned if it had been left in there over the long haul. And that lost return can wind up being in the hundreds of thousands of dollars, depending on how long it is before you retire.

For example, if you’re currently contributing $500 a month to your 401k and getting an employer match, then taking out a $10,000 loan today with 30 years until retirement can cost you a reduction of $411,000 in your retirement balance.

One trap I’ve seen people fall into is having a change in employment while a retirement loan is outstanding. You may be required to repay it in full if you leave the company for any reason. That can be an unfortunate surprise when you can least afford it.

I’m a firm believer that you are the best person to make decisions based on the facts of your situation. So, in this case, before thinking that your retirement account is free money, review your plan, know what the rules are, and either talk to the plan administrator about the actual cost of the loan or find an online calculator to check it out yourself.

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In most cases, tapping your retirement accounts to pay off credit card debt isn’t advisable. The information here can help you understand the difference between retirement account hardship withdrawals and loans. We also explain why these solutions are usually a bad idea just to pay off credit card debt, when it’s acceptable and what you can do instead.

Don’t delay your retirement before exploring your other options. Get a free evaluation to understand your other options for relief.

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Rules for taking money out of your retirement accounts

Taking money out of a 401k

There are generally two ways to take money out of a 401k retirement plan:

  1. A hardship withdrawal
  2. A 401k loan

Not all plans 401k plans allow for hardship withdrawals. That’s up to your employer’s discretion. However, even if your 401k plan does allow for hardship withdrawals, credit card debt usually doesn’t qualify as a reason to make the withdrawal under hardship rules. The IRS outlines six specific reasons you can make a hardship withdrawal:[1]

  1. Paying for certain medical expenses
  2. Costs related to buying a home as your primary residence
  3. Tuition, related educational fees, and education expenses
  4. To cover payments necessary to prevent eviction or foreclosure on your primary residence
  5. Burial and funeral expenses
  6. Expenses related to repairing damage on your home

So, in most cases, you can’t use a 401k hardship withdrawal just because you want to pay off your credit card balances. In this case, you’d be required to take out a 401k loan.

What is a 401k loan?

401k loans have specific terms and conditions as outlined by the IRS.[2]

  • They always have a term of 5 years
  • Payments must be made at least quarterly
  • The maximum loan amount is 50 percent of your vested account balance OR $50,000, whichever is less
  • The loan will have an interest rate, so you will need to repay the money you took out plus interest
  • If you leave your job with the company that you have your 401k through, they may require you to pay the full outstanding balance

In general, the money you take out of your 401k is tax exempt. This includes money taken out through a 401k loan. However, if you leave the company, then the money from the loan would be considered as a distribution from the IRS. In this case, you’d also face an immediate tax penalty as outlined below.

Taking money out of an IRA

If you have money saved in an Individual Retirement Account (IRA), then there are generally no limitations on when you can take money out of it. It’s your money, so you can take it out when you need it. If you’re under the age of 59.5, it’s just considered an early distribution.[3] There are usually tax penalties for early distributions from an IRA that we outline below.

There are two exceptions where you don’t have to pay the early distribution tax penalties if you take money out of your IRA for a specific reason:

  1. You take the money out to pay for higher education expenses
  2. You take the money out to finance buying a first home

In these two cases, you don’t need to worry about early distribution tax penalties. For paying off credit card debt, however, you would face tax penalties.

NOTE: There are no loans for IRAs.

Penalties for taking money from your 401k or IRA

Withdrawal penalties

The first problem with hardship withdrawals from a 401k or traditional IRA is a 10 percent withdrawal penalty. If you take out $20,000 to pay off your credit card debt, then you’ll pay a $2,000 penalty on both of these accounts if the money was taken out as a hardship withdrawal.

There is no withdrawal penalty on a 401k or traditional IRA if you are over age 59½. There is also no penalty for withdrawals from a Roth IRA.

If you take out a 401k loan, then the money will generally not be taxed. However, if you break the terms of the loan as outlined above, then you could face taxes. This includes:

  • Failing to make at least quarterly payments on the loan
  • Leaving the company that provided the 401k plan

Tax penalties

When you take money out of a retirement account, the IRS views that as income. With a 401k or traditional IRA, you’d pay taxes on that money even if you withdraw it once you retire. But if you are under age 59, even Roth IRA withdrawals that will be used to pay off debt will be treated as taxable income.

This means that you should expect your hardship withdrawal to throw off your taxes and your tax refund. For a 401k or traditional IRA, you’re basically facing a one-two punch of penalties with withdrawal penalties plus taxes.

You also risk that the money you take out will bump you into a higher tax bracket.

How hardship withdrawals can change your tax bracket

Let’s say you’re unmarried and make $65,000 annually. According to the IRS, your tax rate for 2019 would be 22%.[1] However, you decide to make that $20,000 hardship withdrawal from your 401k. Now you’d effectively make $85,000 in 2019 because you took that money out of your retirement account.

Instead of a 22% tax rate, you’d be bumped up to 24%. This would decrease the size of your refund or could lead to a tax bill if you usually break even on income taxes.

How much will the withdrawal delay your retirement?

The other reason that using a 401k or IRA to pay off debt is a bad idea is that it can seriously delay your retirement. Instead of retiring at age 65, you may be forced to work a few extra years or keep a part-time job.

It’s important to understand that you’re not just losing the money you withdraw from the account, you’re losing the growth you would have gained on that investment. Depending on how long it takes you to put that money back into the account, you could lose thousands or even tens of thousands in the interim. That puts you behind on achieving your retirement goals.

This impact is greater the older you are. So, let’s say you’re 60 when you make the 401k hardship withdrawal. You’d avoid the withdrawal penalties but still face tax penalties. At the same time, you have a very limited amount of time before you retire. It may be difficult to get that growth back, so you can retire on time.

You may have time to catch up if you’re under age 35

If you’re young and you’ve contributed consistently to one or more retirement accounts since you graduated, then you may have time to catch up to avoid delaying your retirement. You will need to commit to making larger contributions once you’re back to being financially stable.

However, you will still face the withdrawal penalties and taxes described above. So, even in this situation, you should consult with a financial advisor to see how it will affect your retirement goals.

What you should do instead of using your 401k to pay off debt

Before you consider taking money out of your 401k or IRA, you should explore other options for debt relief first. There’s a range of solutions that would help you avoid any retirement delays:

If you’re not familiar with these options, talk to a consumer credit counselor. They will review your debts and budget and explain all the options you have available for relief. These consultations are free as long as you contact a nonprofit credit counseling agency. This lets you get an expert opinion on your best option to get out of debt without incurring another bill.

Talk to a certified credit counselor today to find a solution that will work for your needs and budget.

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Article last modified on July 1, 2019. Published by Debt.com, LLC