Print Article for : 401k To Pay Off Debt

Your Online Guide » Startup Guide » What is 401K

[#1]401k To Pay Off Debt

by Steven Chang, Ste

If you were to ask me if I would cash out my 401K to pay bills or pay off debt, I would not, unless it is my absolute very last resort. There are many ways you can pay off your debt and bills before touching your 401K or your other retirement funds. When you are faced with bills and debts that are piled higher than your eyes, your vision and judgement can be heavily impaired, as if you are driving behind a SUV. The very first thing you should do is really look at your overall financial picture, determine your viable sources of money and decide if you should cash out your 401k to pay bills and your debt.

First step in determining whether you should cash out your 401k is to look at your overall finance. Is the financial trouble you are suffering a temporary thing. For example, are you not able to pay your bills because you lost your job? Events that cause you to lose your primary income may be temporary or permanent. In the case of you losing your job, you have to evaluate and really ask yourself how confident you are in finding another job. If you think it may take you a while before finding work again, or another viable source of income to pay your bills, then look at your assets. Start listing on a piece of paper what assets you have, what kind of assets they are (savings account, cash deposits, stock brokerage account, your home, and or other properties you may have), if these assets are interest bearing (for example, if your savings account is earning any interest), how much interest they are earning, and how liquid is it for you to obtain cash from your assets.

Start going through your list of assets and personal properties and figure out the best source of money to cash out. You will want to compare interest rates - the interest rate of your debt or bills that is being incured, and the interest rate of your money that you are cashing out or borrowing to pay off your debt or bills. In other words, if you are borrowing money from one source to pay off your debt, you will want to find a source of borrowed money that is of lower interest rate charge than the interest rate charge of the debt that your paying off. In addition, if you have some money sitting in a CD or savings account that is earning your a 4% interest rate, and you have credit card debt that is incurring a 16% APR, it would really make sense if you use that money that is earning only 4% interest rate to pay off an account that is charging your 16% interest rate. Your 401k can yield a return that is much higher than a bank savings account or a cash deposit account, if property invested. Therefore, you should think twice about using your 401k money to pay off your debt (aside from possible penalty and interest for cashing out your 401k).

Let's assume that you do not have money available to pay off your bills or debt, what can you do? If you own a home and you have equity (meaning that the market value of your home is higher than the outstanding mortgage balance on the home) in the property, you really should look into getting a cash-out refinance and use the equity of your home to pay off the debt. A cash out refinance is simply the refinancing of your mortgage by obtaining a new loan of higher amount to pay off your existing loan. The amount leftover after paying off your old mortgage is cash in your pocket that you can use. It is quite possible that your monthly payment on your loan will be higher because of a higher loan balance (and also a higher interest rate). But the great news is that the IRS will give you mortgage interest deduction. Therefore, you have essentially turned your credit card debt into a mortgage debt; from an interest charge you can not deduct on your tax return, to interest charge that you can deduct; from bad debt to good debt.

Now, let's assume that you do not have money in your bank account, you do not own a home, and you absolutly do have have any other source of money that you can borrow to pay your bills or to pay off your debt, but a 401k. Then what do you do? Well, desperate times call for desperate measures. If your 401k is truely your last source of money, you will need to consult with your 401k administrator or your employer to see what rules and regulations they have on “borrowing” or “cashing out” on your 401k money. There is a difference between borrowing and cashing out. Most 401k plans will allow you to borrow from your 401k account for use of purchase of your first home, pay your medical bills, pay for education related expenses and other exceptional circumstances (again, consult with your 401k administrator). However, if you were to get money from your 401k for reasons other than those allowed by your administrator or the IRS, it becomes a cash out of your 401k. In the event of you cashing out on a 401k before you have reached 59 1/2 of age, the IRS will consider it an early distribution of your 401k and you may incur a 10% tax penalty (you can visit IRS publication http://www.irs.gov/retirement/sponsor/article/0,,id=151926,00.html for details on the penalty).

Hopefully I have given you enough information and alternatives for deterring you from cashing out your 401k as a source of money to pay off your bills or debt. Everybody's situation will be different and it will be to your benefit to consult with your 401k plan provider or administrator to see the consequences as a result of you cashing out on your 401k.

There is sometimes a sense of panic that sets in when you see your credit card bills begin to spiral out of control. When you are fairly new to that sense of being trapped by credit, you may turn to a second mortgage. But then if the credit card bills continue to grow and grow, as they are designed to do, you suddenly realize you have put your home on the line and it may now be in danger if you default on those bills.

This is when that mountain of debt can begin to knock on the door of your last remaining resources to try to fight back, and you have to make some important decisions. And one is whether it would be a good idea to cash out your retirement money or borrow on your 401K to get enough money to try to reduce your debt levels. So deciding whether this is a good idea is a huge gamble because if you win, you could eliminate debt entirely. But if you lose, there goes your protection for your senior years, and maybe the little nest egg you wanted to pass along to the kids as an inheritance.

Tapping into your 401K to pay off your credit card debt is a bad idea for a lot of reasons. The most obvious reason is that your retirement money is tax deferred so when you put it into that account, you didn't pay any taxes on it. You don't have to pay taxes on it until you take it out. On top of that, the money is intended to stay in reserve until you hit retirement age so in a lot of cases, if you take it out early, there is a big penalty you have to pay.

So right away if you cash out your retirement funds to pay down or pay off your credit card debt, you are losing a lot of money to those penalties and taxes. You might want to calculate how much that penalty is going to be compared to the interest you might save because it's a big pay off just to get access to those funds.

The prevailing logic of tapping into the 401k is that in theory you will save more money from the interest than you would make from the investment. But there is some solid logic for leaving those retirement funds right where they are. For one thing, debt will come and go but retirement funds have a tendency to going away and never coming back. Once you cash out those retirement funds and give the money over to credit card debt, your retirement is gone. But if you find ways to take care of that credit card debt and leave your retirement alone, it is there for you and you have that sense of ownership that the debt has not taken everything from you.

One possible alternative is to borrow against your 401K and use it as collateral. Now in this case you are still just swapping out debt for debt. But secured debt is often easier to get a favorable interest rate and you can cap it so the rate doesn't float around like credit card debt. So there is some rationale for going that route. But if that is an option, you are still putting a very important part of your financial future on the line, so tread carefully.

Article Source : What is 401K

About Author

Both Steven Chang & Trent Cohen are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.

Steven Chang has sinced written about articles on various topics from 401K, Mortgage and tax. . Steven Chang's top article generates over 33100 views. to your Favourites.

Trent Cohen has sinced written about articles on various topics from 401K, Credit Cards. You will find more information on managing debt as well as saving and managing your money better at