Many a times, people consider tapping into the funds of their 401(k) to pay off debt. Some even consider stopping the tax deferred contributions to the 401(k) account to repay any outstanding debt. It may seem as sound option at first, but may have larger pitfalls in the near or distant future.
One of the great advantages of the 401(k) plan is employer contribution. This is kind of free money where an employer matches the contributions made by the employee. Some employers make up to a ‘50 cent to a dollar’ match which translates to 50% of employee contributions and there are some employers who make a ‘dollar for dollar’ match which is like a 100% return on investment.
If one considers of stopping contributions to the 401(k) account to utilize those funds to pay off debt, they should consider this point as to pay off a debt like credit card (which accumulates averagely a 13% interest), they can be sacrificing up to 50%, or worse, a 100% gain on that amount.
Some, in desperate debt situations, may think of making a withdrawal from their 401(k) account. This option however is strictly advised against and should be used only if there are no avenues left and one really ‘has to’ make that withdrawal. Although one has to refer to their summary plan description and/or their plan administrator to check whether they can make such a withdrawal. There are federal rules as well as employer rules that limit the circumstances in which one can make a withdrawal if they are below the age of 59 ½. Also, if the employee is below the specified age of 59 ½, such a 401(k) withdrawal will attract not only a 10% early withdrawal penalty but also the withdrawn amount will be considered as ordinary earning for that financial year and taxed according to the employee’s tax bracket. In such cases where the employee ‘has to’ make a withdrawal, they can consider the option of a 401(k) loan.
In times of dire needs in a debt scenario, the employee can tap into his/her 401(k) savings by means of a 401(k) loan. Again, one has to refer to their summary plan description or/and their plan administrator to understand if their plan has provision for a 401(k) loan. Some of the important aspects to consider when opting for a 401(k) loan are that repayment of the loan is done by payroll deductions where the employee has no say in the decision of the amount deductions and the repayment schedule. Also, if the employee separates from the job for any reason, the loan balance has to be paid in full within 90 days or the balance is termed as a withdrawal. In addition to this, one should consider the impact a 401(k) loan can have on their future savings as the contributions made to 401(k) are tax deferred whereas the deductions made from the payroll for repayment are after-tax. Hence even a 401(k) loan is mostly advised against as well.
Taking all these factors into consideration, it is understood that tapping into one’s 401(k) funds for repayment of debt is profoundly advised against. However, there may be times where one’s finances go into deeper debt scenarios and after exhausting other avenues, accessing the 401(k) is the only option left. In such cases one needs to take up proper planning and caution or hire a financial adviser to clear the debt. Also, one should plan accordingly so that such intense debt scenarios do not occur again in one’s future.
