Dear Penny: When Does It Make Sense to Use a 401(k) to Pay Off Debt?

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Dear Penny,

I am 59, divorced, and have about $20,000 in student loans and $8,000 in credit card debt. My only savings is a very small 401(k) with $17,000 from a job I lost about a year ago.

I am beginning employment with a large reputable business in a couple of weeks. I rent a small cottage month to month, and have a car of sufficient size to live in when necessary.

Should I take my 401(k) money now and pay off my credit card debt and as much of my student loan as possible? I’ve been advised that if I do, I will lose 24% in taxes.


Dear K.,

It’s so tempting to take a bite from the 401(k) apple when you have debt. And your 401(k) funds probably look especially appealing since you’re at or approaching that magical age of 59 ½ when the IRS will let you tap into those funds without paying a 10% penalty.

I’d urge you not to spend your 401(k) to repay your debt, but the tax implications you mentioned aren’t my primary concern.

Your 401(k) is an asset that’s almost always protected from creditors with just a few exceptions, such as if you owe child support or back taxes. The same goes for IRAs and pensions.

That means if you can’t make your debt payments and your student loan servicer or credit card company gets a court judgment against you, they won’t be able to touch your $17,000 in retirement savings. Your retirement accounts are also typically protected if you file for bankruptcy.

That $17,000 could be a lifeline in a crisis — say, if you have a medical emergency or lose your job before you’re eligible for Social Security.

OK, now let’s talk taxes: Your 401(k) withdrawals are taxed as what the IRS calls “ordinary income.” In other words, it’s taxed like a paycheck. So how much would you pay in taxes if you added $17,000 to your paycheck for the year? Without getting into the weeds of how tax brackets work, let’s just say that as a single filer in 2019, you’d need taxable income between $84,201 and $160,725 before any of it would be taxed at the 24% rate you mention.

Specifics aside, let’s just assume that when you start working again, your income will be higher than it will be when you retire. By holding off on 401(k) withdrawals until you’re no longer earning a paycheck, you’ll probably pay less in taxes.

But you’re wise to be focused on getting rid of that $28,000 in debt, especially since your retirement years are approaching.

The good news is, you’re starting a new chapter. You’re about to start a new job, so you’re in a better position to knock out what you owe so that you can be debt-free when you retire — and afford your rent in the meantime.

You don’t say whether the income you’ll earn at your new job will be enough to cover your basic necessities and make your debt payments. If you have extra money left over after bills and minimum payments, start by putting whatever you can toward paying off your credit cards, which probably have higher interest rates than your student loans.

Regardless of how much your new job pays, consider pursuing opportunities to make money on the side so you can tackle your debt quickly and start padding your retirement savings. Even earning an extra $200 or $300 a month through pet-sitting, delivering groceries or driving for a ride-hailing service could help you pay down your debt significantly faster.

By resisting the temptation to take money out of your 401(k) now, you’ll sleep better knowing you have money saved that no creditor can touch.

Robin Hartill is a senior editor at The Penny Hoarder and the voice behind Dear Penny. Write Dear Penny and you might see your question answered in an upcoming column.