Did you know that college students usually graduate with about $25,000 in student loan debt? Statistics show that about 1 million graduates have debts after graduation, which can be higher than $50,000. Having such big debts it may be tempting to withdraw funds from your 401(k) plan as it seems they are just collecting dust until you retire.
In this article, we are going to share with you some useful tips on how to pay off credit card debt and when repaying the debt with 401(k) account makes sense.
The popularity of 401(k) Plans
These retirement plans are becoming more and more popular over the years. Nowadays, approximately 50 million people take part in their recruiters’ 401(k) plans. There are a number of serious reasons to use your retirement savings as the only wise solution, such as when you suffer from a sudden illness, in the case of emergency, or when you need to repay your credit card debt urgently.
However, before you want to withdraw the funds to pay off debt fast or solve any financial difficulty, make sure if you are eligible to drain your account. After that, figure out whether the cost of reduced funds at retirement and taxes will be worth it.
Figure Out Withdrawal Eligibility
The elective-deferral contributions are often the only funds you can withdraw, which are the money deposited beyond the scope of what your recruiter deposited into your retirement plan. Several IRS representatives state that the best way to pay off credit card debt is by using these contributions because the rest of the money contributed by your recruiter is ineligible and therefore can’t be taken as loans to pay off debt.
There are no shortcuts when it comes to getting out of debt. Dave Ramsey
The reason why you can’t use that money is that the recruiter deposited it for the only purpose of your future retirement. The only exception is a layoff, which allows you to use this money for early retirement. Otherwise, you will have to seek other options on how to pay off debt. Also, it would be much better for you if you knew the terms and conditions of your 401(k) plan.
It’s especially significant as in some cases you won’t be allowed to withdraw your money at all – or just in emergency situations such as for fees or tuition, buying a home, major medical expenses, or to prevent eviction or foreclosure (learn about what foreclosure loans are). In order to figure out how to pay off debt fast, make sure debt is considered to be an eligible hardship by your 401(k) plan.
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- This article is for those who haven’t managed to save a million for their retirement.
Remember that there are ordinary income tax and a 10% tax penalty for taking out the funds from your retirement account early. For example, in case you withdraw $50,000 in elective-deferral contributions, you will have to pay $5,000 as an early withdrawal penalty.
More than that, don’t forget that you must pay federal income tax as your retirement account contribution was initially made tax free. Also, you will have to pay tax even if you didn’t deposit the money into your retirement account.
When Paying Off with 401(k) Plan Makes Sense
Some financial planning experts suggest that in some cases it can be beneficial to withdraw some of your 401(k) plan funds to repay a loan with an interest rate up to 20%.
But you need to calculate tax penalties versus interest costs first, before making a decision whether it’s a good idea to cash out money from your account.
There are a few alternative options to reduce interest rates and debt. First of all, discuss the interest with the credit card company. You will have a trump card if you have a good credit score as it will result in your interest rate dropping by several points.
Moreover, you may transfer your balances to credit cards with lower interest or make a few additional payments to reduce the interest rate and the length of the loan.
P.S.: Best tips on how to save for retirement are here.