957. Laura answers a question about using funds in a retirement plan to pay off credit cards and medical debt.
957. Laura answers a question about using funds in a retirement plan to pay off credit cards and medical debt.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from an anonymous voicemail caller who says:
"I'm a government contractor in the process of being laid off due to cuts. I'm not quite sure what to do with my 401(k), which currently has about $30,000 invested. I have about $5,000 of credit card debt and medical bills.
Should I use a portion of my 401(k) before rolling it over into a new 401(k) to pay off that debt, even though I'd be charged a 10% fee?"
Anonymous caller, that's a great question, and I appreciate you leaving the message! If you have a workplace retirement plan, such as a 401(k) or 403(b), there may be times when you're tempted to make an early withdrawal before age 59.5, the official retirement age.
However, before you crack open your retirement nest egg, it's crucial to understand your options. This post will review the rules for early withdrawals and the pros and cons of using retirement funds to pay off debt.
Welcome back to episode 957 of Money Girl–I appreciate you downloading the show! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, and founder of The Money Stack, a Substack newsletter.
You can learn more, ask questions, and sign up for the Money Stack at LauraDAdams.com. Newsletter subscribers automatically receive my Money Success Toolkit with the exact templates I use to manage money.
What are the 401(k) rules?
For 2025, you can contribute up to $23,500 or $31,000 if you're over 50 to most workplace retirement plans. Additionally, many employers encourage saving by "matching" your contributions, up to certain limits, allowing you to exceed those annual thresholds. You choose how to allocate your retirement funds using an investment menu that usually includes index, mutual, and exchange-traded funds.
In most cases, 401(k) plans allow participants to take loans and hardship withdrawals up to certain amounts. Hardships are specific circumstances approved by the IRS, including paying for college, buying a primary home, avoiding mortgage foreclosure, making home repairs, or having unpaid medical or funeral expenses.
However, taking money out of a workplace retirement plan for something like going on vacation or paying off credit card debt is not an approved hardship. The IRS makes it punitive to withdraw money from a retirement plan, so you don't do it. The longer your money stays invested in the account, the better off you'll be in the long run.
A primary downside of a 401(k) hardship withdrawal is that it isn't tax-free. You must pay income taxes on any amounts not previously taxed plus a 10% early withdrawal penalty if you're younger than 59.5. Plus, you typically can't contribute to your retirement account for six months after taking an approved hardship withdrawal.
However, once you leave a job with a retirement account, your vested balance is yours to keep, and you have several tax-free options. As the caller mentioned, you can roll it over to a new employer's 401(k). Another option for managing an old 401(k) retirement plan is to roll it over into an individual retirement account (IRA).
My least favorite option for an old retirement plan is cashing out a portion or all of a retirement account. While that's allowed, as I mentioned, if you're under 59.5, you must pay income taxes on amounts not previously taxed, plus an additional 10% penalty. Depending on your income, average tax rate, and whether you have a traditional or Roth account, that could end up depleting your balance by 25%, 30%, 35%, or more!
In other words, if you have $100,000 in your traditional 401(k) and cash it out at age 40, after paying average taxes of 20% and a 10% penalty, you'd only have $70,000. That's a massive hit to your wealth.
ALSO LISTEN: The ultimate guide to borrowing from your 401(k)
What is a 401(k) loan?
I mentioned that some 401(k)s offer loans. While that's not what the anonymous caller is interested in, I want to explain how they work briefly.
With a 401(k) loan, you tap a portion of your account tax-free if you repay it with interest over a set period, such as five years. If you can take a 401(k) loan, the limit is half your vested balance, up to $50,000. For example, if you have $60,000, the maximum you can borrow is $30,000 ($60,000 x 0.5).
If you repay a 401(k) loan on time, you won't owe income taxes or penalties. However, if you don't, the outstanding balance gets considered an early withdrawal if you're younger than 59.5. In that case, you'd be subject to income tax plus an additional 10% penalty on the entire unpaid loan amount.
Additionally, if you leave your job, get laid off, or are fired, your loan balance will be considered an early withdrawal unless you repay it by your tax filing deadline. Again, if you can't repay it by then, you'll have to pay income tax plus the 10% penalty if you're younger than 59.5.
The main benefits of 401(k) loan include:
The primary downsides of a 401(k) loan include missing potential investment gains on withdrawn amounts and paying an expensive penalty if you don't repay it on time.
RELATED: How should I invest for retirement after a 401(k)?
Can you use a 401(k) to pay off debt?
While you're employed, you can typically use a 401(k) loan but not a hardship withdrawal to pay off debt. As I mentioned, the IRS narrowly defines hardships for workplace retirement plans, and avoiding foreclosure on a primary home is the only allowable debt.
However, once you're no longer employed, you can do anything you like with an old retirement plan. I strongly recommend rolling it over to an IRA so you keep it invested and avoid taxes and penalties. As I mentioned, cashing out some or all of it is an option — but it rarely makes sense due to the high costs.
The anonymous caller didn't mention the interest rate on their debt, but let's say it's 15% or 20% on credit cards or loans. Yes, that's high. However, paying income taxes plus an additional 10% penalty before age 59.5 would likely be even more expensive. The average tax rate for the majority of Americans is from 15% to 25%, bringing the total cost of an early withdrawal from 25% to 35%.
In addition, the caller would incur an even greater loss when considering the lost compound growth over time. Using retirement funds to pay a $5,000 debt solves a short-term problem but can dramatically reduce your future financial well-being. For instance, keeping $5,000 invested for three decades with a 7% average annual return would yield over $40,000.
Tapping your retirement account should be a last resort because you forfeit significant potential account growth. Plus, if you don't have enough cash to pay the taxes and penalty, you might have to withdraw more than you actually need, leaving you with even less in your retirement account to grow.
Therefore, the best advice I can give the anonymous caller is to roll over the entire 401(k) balance into another retirement account and avoid cashing out any amount. The long-term damage would exceed the short-term relief of paying off a relatively small amount of debt.
What are ways to pay off debt?
Instead of draining a retirement account to pay off debt, consider other options that make sense for your financial situation, including:
Counseling services, such as those offered by Money Management International (MMI), can also help determine if you're a good candidate for debt settlement or bankruptcy. Those options have negative consequences for your credit, but can give you a clean slate after a hardship.
RELATED: What is the best debt payoff method?
Thanks again to the caller. The takeaway from this show is that withdrawing retirement funds to pay debt is typically unwise because you likely have better options. Make a goal to keep as much invested so your financial future is as safe and secure as possible.
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team! Steve Riekeberg audio-engineers the show. Holly Hutchings is our director of podcasts, Morgan Christianson is our advertising operations specialist, Rebekah Sebastian is our marketing and publicity manager, and Nathaniel Hoopes is our marketing contractor.