I'm Wondering If I Should Withdraw From My Sad 401(k) And Pay Off My Debt

It can feel so silly to try to save for the distant future in times like this, but everyone tells you to never touch your retirement savings.

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How terrible is it really to withdraw funds from your 401(k) while in your 30s? If withdrawing the funds would cover the debt that you have, then why is it not advised? It seems silly to be saving money if you’re in a large amount of debt. Everything online tells people not to do it, but never gives real-world advice.   

I totally hear you. Anyone with debt who has watched their hard-earned 401(k) plummet over the last year is likely wondering if they’re just funneling their money into a black hole. So I asked Catie Hogan, a former financial adviser who is now a financial educator at Parthean, and Eric Roberge, founder of the financial planning firm Beyond Your Hammock, about this dilemma. 

If a 401(k) were a regular savings or investment account, withdrawing funds for other purposes like paying off debt would be simpler, with fewer restrictions. But except for a few circumstances (such as taking out money for big medical expenses, tuition, or buying a home, scenarios that are sometimes allowed) the IRS assesses a penalty of 10% of the amount withdrawn early from a 401(k), plus taxes.

There’s an option to take a loan from your 401(k) rather than withdraw; this can be preferable to a withdrawal, and the interest you pay on your 401(k) loan actually goes into your 401(k) balance, said Roberge. But if you are taking a loan on your 401(k) to pay off other debt, in a sense, “you're just moving debt from one pocket to the other,” Hogan said. There are also other considerations, like paying back the loan within a certain period of time (typically five years), and penalties if you aren’t able to.

The fact is, the government really wants you to save for retirement — Social Security benefits typically cover only about 40% of wages, after all — so it disincentivizes early withdrawals. 

With all of that said, is it still worth withdrawing from your 401(k) to get that loan out of your life? It depends on how much debt you have and what the interest rate is compared with the average growth rate on your 401k. Those are the details that make the difference. Generally speaking, if your income can cover your loan payments and living costs, don’t dig into your retirement savings, said Hogan and Roberge. And if your retirement fund has grown at a faster rate, on average, than the interest on your loans, you’d probably do better putting any extra money into retirement in the long run. Again, everyone’s situation is unique and the only way to get a personalized assessment is to speak to a professional. 

Also, while it’s possible to compare different financial outcomes, there’s a giant emotional component to money as well that’s harder to assess, and there are people who might just want to get rid of their debt no matter the cost. That’s up to you.   

“The ultimate ‘best’ decision for any individual can only be made with that person's circumstances in mind,” said Roberge. But “99.9% of the time, you probably shouldn't take an early 401(k) withdrawal to pay off debt.”

If you’re really in a pinch and have no other options, you could cash some of your 401(k) out and pay taxes and the penalty, said Hogan. “But it's generally considered a very last resort.”

Sorry, I wish I had better news too. 

Now, it sounds from your question like you have already heard this advice, and you might be curious about how to evaluate the options regardless. You mentioned having “a large amount of debt,” so I worked with Parthean’s Hogan to examine some hypothetical scenarios in which you empty your 401(k) to pay off something big, like student loans. Reminder: These are fake, simplified scenarios for informational purposes only and should not be relied on; also the figures have been rounded for easier reading.  

There’s a lot we need to assume for hypotheticals, so I’ll start with student loan debt of $25,000 (which is typical for undergraduates), with a 5% interest rate. Let’s say you are on a plan to pay it off over 10 years with a monthly payment of $265, and you also put away $265 a month into a 401(k) that is growing about 7% annually (a range from 5% to 8% is normal, but there’s no guarantee on your rate of return). You stick to this plan for five years, but get tired of having student loans looming over you. Here are three hypothetical paths.

Scenario A: Cash out the 401(k)

After five years, you’ve made 60 payments of $265, or $15,900. Alas, $4,900 went toward interest, so there's still a $14,000 balance. (I used this calculator to get these numbers.) You have also been putting $265 into your 401(k) every month. As the investments have grown by 7% annually, there is now $18,868 in the account. 

You withdraw the entire balance of your 401(k) early, paying a penalty of 10% ($1,887) and federal taxes ($3,774, and there could be state or local taxes too). That leaves you with a net withdrawal of $13,208, which is still shy of what you need to pay off the loan, so you would need $792 from savings, for a total payment of $29,900 (that’s the $14,000 balance + $15,900 you paid over the last five years). 

Had you stuck to the original payment plan, 120 payments of $265, the total would have been $31,800 ($265 x 120). By paying off your student loan early, you saved $1,900 in interest, although it came at a cost of $1,887 in penalties for taking money out of your 401(k) early, as well as the potential gains that $18,868 could have earned had it been left untouched in the 401(k). 

Still, you are ecstatic now that you’re free of that debt and decide to double down on retirement, funneling the $265 you had been paying towards your student loans into your now empty 401(k) on top of the $265 you were already putting into it, for a total of $530 per month. It continues to grow at about 7% annually, and in five years the 401(k) is worth $37,700. 

Bottom line: 10 years in, you have no student loans, and you paid $4,900 in interest. You have a 401(k) with $37,700 in it. Retirement is a long game of compound growth. That $37,700 has the potential to grow to more than $205,000 in 25 years if it keeps growing at 7% (again, that 7% is not guaranteed).

Scenario B: Don’t cash out the 401(k)

In the conventional approach of leaving the 401(k) untouched and paying off the loan over 10 years, you would make 120 payments of $265 for a total of $31,800 in student loan payments. Your 401(k), which has consistently been getting deposits of $265 each month and has been growing by an average of 7% per year, would be worth $45,300

Bottom line: 10 years in, you have no student loans, and you paid $6,800 in interest. You have a 401(k) with $45,300 in it. That $45,300 has the potential to grow to more than $246,000 in 25 years, a big difference from Scenario A.

Parthean’s Hogan said that, in general, “you are sabotaging the financial well-being of your future self” by emptying a 401(k) early. “It's hard to know what the future will look like, but you aren't doing your future self any favors,” she said.

Scenario C: Don’t contribute to the 401(k) until the loan is paid off 

In this hypothetical, you don’t withdraw from your 401(k) to pay off your loan early, but you decide not to contribute a penny to it, and funnel that money toward extra payments on your loan until it is gone. With an extra $265 each month going toward your $25,000 student loan from the very beginning, the loan would be paid off in about 4.5 years. Then, you could put that monthly $530 in your 401(k), which, let’s assume, grows at 7% for the remaining 5.5 years. 

Bottom line: 10 years in, you’d have no student loans and you pay the least amount in interest here, $2,900. You have a 401(k) with about $43,000 in it. That $43,000 has the potential to grow to more than $234,000 in 25 years. 

This is not a great choice if your employer has a generous 401(k) matching benefit (you’d basically be leaving money on the table if you don’t maximize that benefit by contributing). But if your company does not offer a match (or a retirement plan at all), this option saves you in interest payments and dodges the 10% early withdrawal penalty in Scenario A.  

I inadvertently took a path like this because for years I worked in jobs that didn’t offer retirement benefits, like 28% of US workers do. There was no 401(k) plan available to me. So I saved that money and put it toward my student loans, which I hated having. When I finally got a job that offered a 401(k) plus a match, I maximized the match and contributed more when I could. It’s not a terrible outcome, although in my 30s, I felt I had a lot of catching up to do if I ever wanted to retire, and mathematically I would have come out ahead if I had started out at jobs with better benefits. 

In reality, there are lots of factors to consider: the actual interest rate on your loans, how your 401(k) performs, what your tax rate would be on an early 401(k) withdrawal, whether you remain steadily employed during that period, and how many unexpected expenses come up. If the interest on your loan is much higher than the returns on your 401(k), the numbers work out very differently. If you’re on a payment plan that is longer than 10 years — which means you’re paying more interest — it also works out differently. 

You can do the comparison with your own numbers. There are various calculators available online to help with estimates. Some state government agencies provide calculators for understanding student loan repayment schedules (see New York’s here and a federal version here). And here is the SEC’s simple compound interest calculator, which demonstrates the potential growth on savings, such as a 401(k). (Many bank websites also have 401(k) calculators that can take your actual income into account.)

With the market being down so dramatically recently, it can feel like saving for retirement is equivalent to setting money on fire, so the temptation to move it somewhere better is understandable. It’s also hard to care about your quality of life decades down the road when things are challenging today. But “by taking money out of the 401(k) now you aren't giving your account a chance to rebound from this recent downturn,” Hogan said. “The markets are cyclical in many ways, as is our overall economy. We see boom times, like the past 13 years in the market, followed by a downturn, followed by a recovery.” 

No one really knows what will happen to the market. But it’s hard, if not impossible, for most of us to try to increase wealth or save for retirement any other way. This is the imperfect system we’ve been given. ●

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