When to tap your 401k to pay off debt, and when not to

You’re undoubtedly aware of the importance of regularly contributing to a retirement account.

You’ve also likely been told not to use those savings until your retirement. After all, one day, when you no longer wish to work, they’ll serve as your main income.

For many people, this savings approach is an automatic recurring contribution to a 401k. It eliminates having to actively think about saving and separates retirement money from your day-to-day spending.

In a sense, it’s a set-it-and-forget-it approach.

But what if there are times when withdrawing from your 401k to pay off debt can be a prudent financial move?

It might seem counterintuitive, but sometimes using retirement funds to cover debt is a good “investment” opportunity.

Four things to consider before withdrawing cash from your 401k

Any redemption from your retirement savings shouldn’t be taken lightly. Before using a 401k to pay off debt, consider the following:

1. Taxes: Regardless of age, withdrawing funds from a 401k is treated as ordinary income. For example, from a tax perspective, if you redeem $10,000 from your account this year it’s considered the same as if you’d earned an additional $10,000 in employment income. So, if your effective tax rate is 20%, you’ll owe an additional $2,000 in taxes because of that withdrawal.
2. Penalties: Redemptions from a 401k before the age of 59 ½ prompt a 10% early withdrawal penalty. This amount is over and above any tax implications. Although, sometimes, the penalty can be avoided by taking out a loan from your 401k. Typically, these loans must be repaid within five years.
3. Loss of tax-advantaged growth: Investments in a 401k grow tax-free. While your funds remain in your 401k, you don’t pay capital gains taxes, even when you buy and sell stocks. You are only taxed when the funds are taken out. So redeeming early means you’ll lose out on valuable tax-free growth.
4. Restrictions: Certain plans, like an employer 401k, may include conditions and rules preventing withdrawals.

When should I use my 401k to pay off debt?

Deciding whether to use your 401k to pay off debt comes down to math.

Imagine a credit card balance of $5,000 with a 24% APR. This works out to $1,200 per year in interest.

Presently, you can only afford to make minimum payments. As a result, it might be wise to access funds from your retirement account to cover this debt.

Assuming you’re under 59 ½ years old, if you withdraw $5,000 from your 401k, you can expect the following costs:

• $500 penalty (10% of $5,000)
• $1,000 in taxes (20% tax rate)

But that’s not the only cost. There are also foregone opportunity costs.

Presumably, your 401k holds investments, like stocks and bonds. If you’re averaging a return of 7% per year, you’re losing a potential $350 in returns by decreasing your retirement account by $5,000 (7% of $5,000).

Put another way, using $5,000 from your 401k to cover debt means removing the opportunity to earn a return on that amount.

In total, the cost to redeem from your retirement account in the first year equates to $1,850 ($500 penalty + $1,000 in taxes + $350 opportunity cost).

That is $650 higher than the debt service amount of $1,200. So at first glance, this does not seem like a smart move.

But, after one year things shift. Starting in year two, assuming you're still making minimum payments on the credit card, you’re continuing to pay $1,200 in interest annually.

At the same time, the total 401k cost is now only the opportunity cost of $350 since the initial penalty and taxes were one-time costs.

In year two, your benefit is $850 ($1,200 interest payment less $350 in foregone stock returns). This benefit continues as long as you maintain the credit card balance.

Therefore, in this scenario, using your 401k to pay off debt makes financial sense.

Of course, it’s important to remember that this scenario is an estimate. Unfortunately, we can never know how our investments will perform. The 7% growth rate may be too generous or too conservative.

When it's not advisable to use your 401k to pay off debt

Using your 401k to pay off debt is not advisable if you expect the net cost to be higher than the debt servicing.

Take the same example above, but let’s assume you expect the stock market to perform exceptionally well over the next few years and your retirement portfolio to return an impressive 30% annually.

Does it still make sense to withdraw funds to cover the debt? Let’s see.

Year 1

• Cost to withdraw from 401k: $1,000 tax + $500 penalty + $1,500 opportunity cost (30% return on $5,000), for a total cost of $3,000.
• Cost of debt: $1,200
• Net cost during year 1 = $1,800 ($3,000 less $1,200)

Year 2 and beyond

• 401k cost: $1,500 opportunity cost
• Cost of debt: $1,200
• Net benefit during year 2 = $300 ($1,500 less $1,200)

Assuming your investments continue to earn an average of 30%, in this scenario you’re better off not paying off the debt.

The $300 benefit each year beginning in year two means it will take roughly seven years to overcome the first-year cost of $1,800. After seven years, however, you’ll be better off.

So, should you use your 401k to pay off debt?

As the examples above illustrate, it depends. Whether you should use your 401k to pay off debt comes down to a cost-benefit assessment.

To recap:

• If it costs more to redeem from your 401k than it will to service your debt, do not pay off debt with your 401k.
• Alternatively, consider using your 401k to pay off debt if it costs less to redeem from your 401k than servicing it.

For most people, paying off debt is often the best move. APRs can be steep, providing a challenging cost hurdle to overcome.

In the second example, it was assumed the retirement account could earn 30% annually. In reality, this type of return year after year is almost unheard of.

In other words, it’s critical to ground your assumptions in reality. And, of course, do the math.