When using your 401(k) to pay off debt makes sense

Employer-sponsored 401(k) plans form a retirement-planning cornerstone for millions of Americans.

These accounts allow workers to save money for the future through payroll deductions at work and, in many cases, provide an employer match that can significantly bolster retirement nest eggs.

Those participating in 401(k) plans may contribute up to $19,500 this year, according to the IRS, plus another $6,500 in catch-up savings for workers age 50 and older. Besides saving for the future, employees can lower their current income tax bills by contributing to these tax-deferred accounts.

Financial experts tend to recommend leaving your 401(k) alone and letting the money grow so you’ll have it later in life. Current financial needs, however, may tempt you to tap into your retirement account now.

Understanding your 401(k) and possible penalties

Drawing money from your 401(k) can come at a cost, which will vary depending on your age and the way you take the funds.

If you’re under age 59 ½ and make a hardship withdrawal, you’ll pay a 10 percent penalty for getting a hold of those funds early, plus income taxes; the withdrawn amount counts as income and may even boost your tax rate. If you’re at least 59 ½, you’ll avoid the early-withdrawal penalty but will owe regular income taxes on the withdrawal.

A more reasonable choice may be a 401(k) loan, which carries a relatively low-interest rate. With this option, you repay your own retirement account over time and avoid the early-withdrawal penalty and income taxes. The only drawback, assuming you stay at your job, is the missed chance for your money to grow with the market.

SHOULD YOU LOWER 401(K) CONTRIBUTIONS TO PAY OFF DEBT?

You can borrow up to half your 401(k) balance, but no more than $50,000. A word of caution: If you leave your job before you’ve repaid a 401(k) loan, your company is likely to treat the balance as a withdrawal, which means you’d face income taxes and the potential penalty.

Also, as financial guru Suze Orman noted, you’ll be taxed twice on the money used to repay your 401(k) loan – once when you earn it, and again when you withdraw it years later in retirement.

Given those caveats and the need to carefully consider the ramifications, here are some reasons you might turn to your 401(k) to pay off debt years or decades before retirement.

You’re struggling with high-interest debt

If you’re carrying balances on credit cards with oppressive interest rates, you could come out ahead by taking a low-interest 401(k) loan. Imagine trading a credit card balance with a 16 percent interest rate for a 6 percent interest rate 401(k) loan.

A heavy debt burden poses a risk to your financial security. In fact, financial expert Dave Ramsey recommended eliminating debt before saving for retirement, even if it means sacrificing a company 401(k) match for a year or two.

SHOULD YOU PAY OFF CREDIT CARD DEBT WITH A 401(K) LOAN?

(The National Foundation for Credit Counseling recommended that retirement-age people with substantial debt avoid draining 401(k) funds and instead consult with a non-profit debt counselor.)

You’re buying a home

Many younger workers scoop into their retirement accounts to come up with a down payment on a house. If homeownership is a priority and you don’t have access to another sizable chunk of funds, a 401(k) loan may be a reasonable option.

You encounter an emergency

If you suddenly faced a costly medical emergency or another urgent situation that might plunge you into new or greater debt, 401(k) funds could save the day.

You’re desperate to avoid bankruptcy

Using your 401(k) to pay off debt to avoid bankruptcy may not be the wisest move, given that U.S. bankruptcy courts generally shield retirement accounts. You might decide to go this route anyway for professional or personal reasons. It’s worth consulting with a financial professional or lawyer.

Consider other funding sources

Before you reach into your 401(k), consider alternatives, including negotiating with creditors to lower your interest rates, reduce your balance or put you on a payment plan.

Debt.org cites other possibilities, including nonprofit credit counseling, which can provide a debt-consolidation plan, or finding a reasonable home equity loan. You also might use a family loan or transfer a high-interest balance to a zero-interest credit card.

Consider talking to a professional to help you make the best move.