Don’t Use Your 401K to Pay Off Debt

401k

People often move money around especially to pay off debt. This can make a lot of sense. However, be careful about the choices that you make when shifting your money. For example, don’t use your 401K to pay debt.

Virtual Money Makes Moving Money Easy

I rarely carry cash. I don’t write checks. When people send me checks, I immediately deposit them using mobile banking. In other words, my money is pretty much all virtual. It’s numbers on a screen. That makes moving money around so simple.

In fact, the moves are often automatic. I get a PayPal deposit and move it to my checking account where it automatically gets dispersed into savings or to pay bills. I pay for items on credit cards in order to earn rewards then those bills automatically get paid monthly via checking. I set up the systems and the money just moves itself.

Mostly this is convenient. It’s primarily a good thing, at least for me. However, the fact that it’s so easy to shift money also makes it easy to make mistakes.

It Doesn’t Feel Painful to Pull From Your 401K

The fact that our money is so virtual oftentimes means it doesn’t feel all that real. Therefore, spending it doesn’t always feel as painful as perhaps it should. In particular, it doesn’t always hurt to pull money from savings accounts. If it’s an account that you rarely look at then it’s even less obvious.

For example, it should be painful to pull money out of your 401K. It costs you penalties when you do. Moreover, you are robbing your future self of money you’ll need in retirement. And yet, because it’s so easy to move that money, and because you probably don’t even look at your 401K account very often, it doesn’t feel as awful as it is.

Don’t Use 401K Money to Repay Debt

Our debt is often right in our face. I’ve gone paperless myself, but I still get notices and updates about what I owe. My accounts are hooked up to Mint, which I check regularly for budgeting. As a result, I see my debt often. It stresses me out when it gets too high. I want to pay it off. However, there are good and bad ways to repay debt. Digging into your 401K to pay off debt just doesn’t make sense.

Believe me, it’s tempting. There’s such a thing as a 401K loan. In other words, you borrow money from yourself directly out of your 401K. You even pay the interest back to yourself. However, you have to remember that this is a very high-risk way to pay off your credit cards. One problem is that you risk tax penalties.

The Issue of Bankruptcy

Tax penalties are only one problem of using 401K money to repay debt. Another that may be much more problematic has to do with the issue of bankruptcy. Money reports on the details of this common problem. The gist of it is that if you use your 401K to pay your credit card debt, then you haven’t addressed the underlying issue of what’s caused the debt in the first place. As a result, you’re likely to get right back into debt. This could lead you to eventually need to file for bankruptcy.

In fact, more and more people are filing for bankruptcy after the age of 65. In other words, people are filing for bankruptcy once they retire. The good news for those people is that 401K money is often protected in bankruptcy. If you have that money in your 401K then you can still use it even if you have to file bankruptcy to discharge credit card debt. However, if you used up your 401K to repay debt but then later still have to file bankruptcy, that money is just gone.

Moving money from your retirement savings to repay credit cards is easy. It can be very tempting. However, it’s a mistake. Don’t do it.

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