What is a 401(k) plan – 4 Benefits and when to pay off debts with it
Planning for retirement is very important so that you can live a peaceful financial life during your golden age. Thus you should invest money into retirement accounts once you start earning money in our youth. There are many types of retirement plans available. But 401(k) retirement plan is one of the most significant retirement plans made for the people who work under an employer. The 401k plan in general is considered to be a good retirement investment option that can help you save money for the time when you won’t be able to have a regular stream of income.
What is a 401(k) plan?
The retirement plan that is offered by the employers to its employees is known as 401(k) plan. In a 401k plan, the individual and the employee both can contribute to this retirement fund. In the case of Individual Retirement Account (IRA), the individual can contribute to their account that is opened for personal retirement savings.
How does a 401(K) plan work?
In a 401k saving plan, the monetary contributions are usually automatically deducted from the paycheck of the employee. One part of the contribution is made by the employer. The employee money is saved in the account without any tax cuts, so you are saving more. Traditional 401(k) accounts give tax breaks. However, you have to pay a tax during the time of the withdrawal.
What are the benefits of a 401k? Why is it important?
- Employer matches your contribution
- The distributions on 401(k) are tax-free
- Maximize tax-sheltered asset
- Helps to save
If your employer offers a contribution to your 401(k) plan, then you should contribute to 401(k). Usually, employers contribute 50% of what you’re contributing to a 401k account. The contribution is taken out before the employee’s paycheck is taxed. The contributions are invested at the employee’s direction into one or more funds provided in the plan. Employers often “match” employee contributions, but are not required to do so.
Traditional 401(k) gives a tax break when you save for retirement, but during the time of withdrawal, you have to pay taxes. When your investment is growing in the employee’s 401k account, you do not pay any taxes on it. Youngsters are recommended to invest in a Roth IRA and let it grow for 30 or 40 years. If you withdraw after the age of 59 and ½ years of age, you’ll pay tax in a much lower tax bracket.
With a traditional 401(k) plan, you do not get the entire savings to spend in retirement since you have to use some of the balance to pay income tax on the withdrawal.
As you are contributing money and saving before it is taxed, you are saving more. Thus, it helps you to start saving right from a young age and save a good amount for retirement.
Should you withdraw from your 401(k) account to pay off credit card debt?
If you are in huge credit card debt and you are in financial hardship, you can use your retirement savings for eliminating your liabilities. But, before you go for this, you should know the outcome of considering it.
You will be charged a fee
When you make use of your personal retirement accounts to eliminate credit card debt, consider the expenses involved. The process is usually very expensive and will take a heavy toll on your retirement savings ahead of even paying off any debt. You’ll be required to pay a 10% distribution penalty to the IRS or Internal Revenue Service. If you receive the cash from a traditional IRA, you’ll be required to pay a certain amount of income tax on the funds that you obtain. In case you receive capital from 401(k) plan and Roth IRA, you needn’t pay taxes, but you’ll be required to pay a certain amount of fine on any investment income that you confiscate.
Thus, a significant part of your retirement savings will not be directed in paying off your credit card debt.
You will be charged a fee
When you make use of your personal retirement accounts to eliminate credit card debt, consider the expenses involved. The process is usually very expensive and will take a heavy toll on your retirement savings ahead of even paying off any debt. You’ll be required to pay a 10% distribution penalty to the IRS or Internal Revenue Service. If you receive the cash from a traditional IRA, you’ll be required to pay a certain amount of income tax on the funds that you obtain. In case you receive capital from 401(k) plan and Roth IRA, you needn’t pay taxes, but you’ll be required to pay a certain amount of fine on any investment income that you
confiscate. Thus, a significant part of your retirement savings will not be directed in paying off your credit card debt.
The profit margin will be lower in the future
When you are making use of your 401(k) and IRA funds to eliminate debt, you might be taking a short- term approach. Once you do this, you’ll be pulling out cash that has taken years to collect.
It might take a very long time to get back on track with your finances. If you extract the cash from your retirement account, it won’t be able to earn returns, probably costing you hundreds of dollars in future retirement cash that you might have had.
Does not solve the debt problem permanently
The huge credit card debt usually results from spending more cash than you earn or may afford to spend. If you are extracting money out of your IRA to pay off your credit card debt, you aren’t actually solving the problem that has led you to this situation. If you don’t fix the real problem, you will certainly end up incurring even more credit card debt after you take out money from your IRA account.
You need to take out a 401k loan to pay off credit card debt
If you want to get out of debt using your retirement savings, you need to take out a 401k loan to pay off credit card debt. If you take out any money from the IRA account before you’re 59 and half years of age, you may have to pay a 10% penalty. That can be a huge blow to your finances.
When Paying off Debt With Your 401(k) loan Makes Sense
From a simple number perspective, paying off credit card debt with a retirement fund makes sense. But taking out money from a retirement account is not an easy task. The money that is in your retirement account is money that has not had any tax taken out of it. But when you withdraw money from a retirement account, it is considered as a generated income and will be taxed at 25 percent. Therefore, it becomes difficult to get back to the point where you had started.
However, the most advantageous thing about borrowing money from a retirement plan is the interest rate attached to it. With credit cards, interest rates are typically high. For example, you may be paying 20 percent interest on some of your credit cards. But on the other hand, with a 401(k) loan, you may only have to pay around 6.5% and 7.5%interest rates. So, by taking out a 401k loan to pay off credit card debt, you can save some potential amount on interest.
Is Using a 401k or IRA to Pay Off Credit Card Debt a Bad Idea?
Credit card debt has become one of the most common financial obligations of almost all individuals and families. People can incur credit card debt due to many reasons like extravagant holidays, medical expenses, renovating houses and low income. However, no matter how you fall into debt, you must try to come out of it as soon as possible. There are several ways to remove credit card debt like debt consolidation, debt settlement, and bankruptcy. Another way that some people consider is cashing out 401k to pay off debt. But is it a good idea to borrow money against a retirement account and pay off the balances on credit card debt?
The primary goal of borrowing against retirement funds is to pay off the credit card bills as soon as possible. Most 401(k)s allow people to borrow money through a 401(k) loan. So you have to take the money from the loan and pay off the credit card debt. After you complete paying off your credit card debt, you have to start making loan payments to clear the 401(k) loan.
Thus, it can be said that taking out a loan from or against a retirement account gives you temporary relief from the shackles of credit card debt. People mostly incur credit card debt due to the indiscreet use of credit cards. So the main solution to credit card debt is the modification of spending habits. Unless and until you change your behavior towards the use of a credit card, it will not do any good to you. You may end up with a large credit card debt again and then have to deal with a 401(k) loan.
Remember, the final decision has to be taken based on how much money you could save over the long run and your current budget as well. If you think you cannot afford to repay your existing credit card debt but can afford a 401(k) payment, then you may consider borrowing the money from your retirement account.
Lastly, even though utilizing your retirement savings to eliminate credit card debt has certain drawbacks, it also has a constructive side to consider. Once you start paying off your credit card debt, you can actually save a considerable amount of cash in interest charges. A majority of the credit card companies charge high rates of interest, and it would not be possible for you to repay it. However, you will have to try and avoid withdrawing funds from your retirement account to avoid drying it up. This should mainly be kept for the retirement period. Moreover, in the case of the 401k, if you withdraw funds from it, you will unnecessarily end up losing more and more money. If you want to know how much you can withdraw, then you can use a 401(k) calculator.