Using your 401(k) to pay off debt: What are your options?

Can I use my 401(k) to pay off debt?

You can technically use a 401(k) to pay off debt, but doing so may be less than ideal for more reasons than one. For starters, accessing funds from a 401(k) through a loan or some type of withdrawal means that money won't be growing and compounding to help pay for your retirement.

Ultimately, tapping into your 401(k) now means you're borrowing from your future self, which could leave you short on retirement funds and working longer. Not only that, but there are fees and consequences involved in accessing your 401(k) early, although they vary based on the strategy you use.

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Borrowing from your 401(k) to pay off debt

You may or may not be able to take on a 401(k) loan for any purpose, including paying down debt. That’s because while employers that offer tax-advantaged retirement accounts can provide an option to take out a loan from them, they're not required to.

Christopher Stroup, a financial advisor at Abacus Wealth Partners in Santa Monica, California, says you need to read the fine print of your employer plan since those that do offer these loans have their own unique set of rules. For example, 401(k) loans are only for active employees in most cases, so you would be ineligible if you no longer work with the company that offers the retirement plan.

"This is one of the many reasons it can benefit you to consolidate old retirement plans into your current employer retirement plan," Stroup said.

You may be able to borrow as much as 50% (up to $50,000) of your total savings, but you must pay it back with interest within five years.

Depending on the rules of your employer’s plan, you may be able to borrow as much as 50% of your total savings, up to $50,000, within one year. In most cases, you must pay back 401(k) loans with interest within five years of taking out the loan.

"It’s important to read the fine print of your employer plan, as it will outline rules surrounding the maximum number of loans you may have outstanding from your plan," Stroup said. "It may also require that you obtain spousal or domestic partner consent prior to taking the loan."

Note that you don’t have to pay taxes or penalties when you take out a 401(k) loan, unlike if you take a withdrawal directly from your 401(k). Interest paid on the loan also goes directly into your retirement account.

But Stroup points out that one major drawback of 401(k) loans is that if you leave your current job, you might have to repay your loan in full much faster than you originally planned. There are also additional consequences to consider if you can’t repay the loan.

"If you’re unable to repay the loan for any reason, it's considered defaulted, and you'll owe both taxes and a 10% penalty if you're under 59½," he said. "You'll also lose out on investing the money you borrow in a tax-advantaged account, which means that you miss out on potential investment growth over the long term that could amount to much more than the interest you'd repay."

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Withdrawing from your 401(k) to pay off debt

You can also withdraw money from your 401(k) before age 65 or the plan's normal retirement age without taking on a loan, which means you have no obligation to pay the money back. Most of the time, withdrawals considered early from a 401(k) or an IRA take place before the age of 59½.

However, this move requires a penalty of 10% on the amount you take out. You would also owe income taxes on the amount taken from your 401(k) since deposits were initially made on a tax-advantaged basis.

Hardship withdrawal

Some 401(k) plans offer a hardship withdrawal provision that lets members access some of their funds for exceptional financial need. However, these withdrawals must be limited to the amount necessary, and you can typically make withdrawals from contributions and not earnings.

Like early withdrawals, hardship withdrawals are also subject to standard income taxes and a 10% early withdrawal penalty unless you qualify for a specific list of exceptions. For example, you can skip paying the 10% penalty if you're dealing with total and permanent disability or have a significant amount of unreimbursed medical bills in a given year.

» MORE: What is an IRA?

When should you use a 401(k) to pay off debt?

While Stroup says his firm would never recommend using a 401(k) loan or tapping into 401(k) funds to pay for entertainment and gifts, there are scenarios in which using retirement money could be beneficial.

"For example, using a 401(k) loan to pay off high-interest debt could minimize the amount you pay in interest to lenders," he said.

Further, 401(k) loans may be better for debt consolidation than other types of funding if you have less-than-perfect credit. Stroup says this is because 401(k) loans don't require a credit check and won’t appear as debt on your credit report, whereas balance transfer credit cards and debt consolidation loans require a credit check, and terms can be unfavorable for those with fair or bad credit.

Stroup says it could also be beneficial to use a 401(k) loan to fund major home improvement projects that raise the value of your property enough to offset the fact that you’re paying the loan back with after-tax money and any forgone retirement savings.

Otherwise, it's almost always a smarter financial move to leave your retirement savings fully invested and find another source of cash. This is especially true for early and hardship withdrawals, which typically require you to pay income taxes and a penalty to access your money.

» MORE: Should you get a personal loan to pay off credit card debt?

Alternatives to paying off debt with a 401(k)

Before you dip into your 401(k) funds to pay off debt, consider other financing options that won't leave you at a disadvantage for retirement.

• Balance transfer credit cards: If you have good or excellent credit, paying down debt with a balance transfer credit card can make sense. Cards in this space offer a 0% annual percentage rate (APR) on balance transfers for up to 21 months, although an upfront balance transfer fee will apply.
• Home equity lines of credit (HELOC): If you have considerable home equity, you may be able to use your home as collateral and take out a HELOC. These lines of credit let you borrow money as needed and typically come with variable rates. But if you fail to keep up with payments on a HELOC, you put your home at risk of foreclosure.
• Home equity loans: Home equity loans also use the value of your home as collateral, and they come with fixed interest rates, fixed monthly payments and a set repayment plan. But if you fail to keep up with payments, you risk foreclosure.
• Personal loans: Personal loans are popular for debt consolidation since they come with competitive fixed interest rates, a set repayment schedule and a monthly payment that stays the same for the life of the loan.

Bottom line

Using money from your 401(k) to pay down debt may seem like the easiest thing to do, but there are downsides. If you take out a 401(k) loan but leave your job early, you could end up having to repay all the loan funds immediately. And don't forget that most early withdrawals require you to pay income taxes and a 10% penalty unless you qualify for an exemption.

If you have any other means to pay down debt, you're probably better off going that route. Start by looking into personal loans, balance transfer cards and various home equity products that let you pay down debt without messing with your retirement.