Is it Wise to Withdraw From a 401(k) to Pay off Debt?

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While leading a debt-free life reduces stress and creates freedom to use money for important things, tapping a company 401(k) is not a wise way to do this. Although it's tempting to raid the retirement fund for more immediate needs, it's an expensive way to manage your money and a risky gamble to take with your future. The Internal Revenue Service levies tax penalties for early withdrawals, which are those made before you are at least 59 1/2 years old.

Tax Bite on the Front End

Money going directly into a 401(k) escapes taxation, but this reprieve is temporary. All taxes are deferred until it becomes actual income, whether as a post-retirement payout or an early withdrawal. By law, the plan administrator must withhold 20 percent off the top from any money taken out before retirement.

A Second Tax Bite

Besides the 20 percent taken off the top from a 401(k) withdrawal, the IRS grabs an additional 10 percent from early withdrawals to penalize you. These taxes and penalties will trim a $1,000 401(k) withdrawal to $700. If the money is not put into another retirement fund within 60 days, it is treated as income and you'll have to report it as such on your income tax.

Leaving Money on the Table

Most company-sponsored 401(k) plans include matching funds from an employer as part of a profit-sharing arrangement, and this match is usually determined by the balance of the fund. If the fund is not fully vested, cashing out the 401(k) early will also affect that source of free money.

Borrowing Against the 401(k)

While you can borrow from a work-sponsored 401(k), you will still miss out on some matching funds while the money is missing from the retirement fund. If you leave the company through a layoff or take another job elsewhere, the debt is payable immediately and the company can call the loan.

The Uncertainty of Retirement

There's no way of predicting what retirement benefits might await you from Social Security, as Congress frequently changes -- or talks about changing -- the age at which people can retire with full benefits. A well-managed 401(k) can provide a good income source for retirement, but not if you tap into it while it still can be earning money.

Alternatives to Smashing the Nest Egg

Rather than tapping your retirement fund, find other ways to generate more income or conserve your disposable income. An audit of the household budget may show underused but expensive services. Cable TV and cell phone services can be reduced and the money set aside to pay bills. If you're really interested in paying off a debt, you should be able to find some money to do it without mortgaging your future.