When your debt is piling up, you want to exhaust all your financial resources to pay your bills. People drain their savings, borrow from family, or take out personal loans. But these options can leave you completely cash-poor, beholden to someone else, or stuck with another debt to pay off. If you’re employed and paying into a retirement fund, you may be wondering if it makes sense to use your 401(k) to pay your debts.
Reasons to Avoid Using a 401(k) to Pay Debt
Employees under the age of 59 ½ are often permitted to take a loan out of their 401(k) accounts. Your employer can set up automatic repayments from your paycheck, and you essentially pay yourself the principal and interest. If you’re planning to be in the workforce long after the loan is repaid, it may seem like an ideal situation. You can get a loan without filling out much paperwork, and you are the only one who benefits because you repay yourself.
However, it’s not usually a good idea to take a loan from a retirement account. Those funds exist to help you build a proper nest egg for when you reach an age where you are no longer able or no longer want to work.
If you’re considering this type of loan, keep these four points in mind before finalizing your decision:
- You could get hit with an early withdrawal penalty. Repaying the loan is simple when you’re working, but what happens if you leave your job before the loan is fully paid off? In this instance, the unpaid balance automatically becomes ordinary income for that year, which means you’re taxed on it. Additionally, if you’re under 59 ½, you will be charged a 10% early withdrawal penalty on the unpaid balance of the loan.
- Anything unpaid becomes taxable income. 401(k) contributions are pre-tax dollars that get taxed when you withdraw at retirement. The assumption is that your income tax rate will be much lower after you’ve left the workforce, meaning the amount of taxes withheld from your retirement payouts will be lower. However, if you’re forced to take an unpaid loan portion as ordinary income, you’re taxed at your current rate, which could be much higher. Take a look at Ohio’s income tax rates to get an idea of how much money you pay.
- You will get taxed twice. Initial contributions to a 401(k) are made with pre-tax dollars. However, your repayment comes from post-tax contributions. When you retire, those repayment amounts will end up getting taxed again, since there’s really no way to separate them from the pre-tax money.
- You’ll lose out on investment earnings. Most contributors put their 401(k) into mutual funds in an effort to earn more on top of what is added. Any money that is taken out of your retirement account is money that is not benefitting from investment earnings. Suppose you take money out that takes two years to repay, and in those two years, the stock market has had some considerably positive return rates. The $10,000 or $20,000 (or more) you withdrew will not be exposed to this financial gain.
Talk To an Ohio Debt Management Lawyer
There are plenty of options to consider before tapping into your retirement funds to pay off a loan. Talking to a debt management attorney allows you to learn more about what you can do. The attorneys at Luftman, Heck & Associates have helped numerous people with debt problems.
Call us today at (888) 726-3181, or e-mail us at firstname.lastname@example.org for a free and confidential consultation.