Can You Take Out Money From 401k to Pay Off Debt?

A 401(k) plan is a foundational retirement savings vehicle, allowing individuals to accumulate assets on a tax-advantaged basis for their post-employment years. Designed for long-term growth, these plans encourage consistent contributions and investment over decades. However, financial challenges sometimes arise before retirement, leading individuals to consider accessing these accumulated funds.

Using a 401(k) Loan

A 401(k) loan allows individuals to borrow from their vested account balance, essentially borrowing from themselves. This option is not universally available, as employers determine whether their plan will offer a loan feature. The maximum loan amount is the lesser of 50% of the vested account balance or $50,000. An exception exists where if 50% of the vested balance is less than $10,000, one may borrow up to $10,000.

Repayment of a 401(k) loan typically occurs through automatic payroll deductions, ensuring consistent payments. The law generally requires loans to be repaid within five years, with payments made in substantially equal installments at least quarterly. A notable exception allows for a longer repayment period, potentially up to 15 years, if the loan is used to purchase a primary residence. The interest charged on a 401(k) loan is repaid back into the borrower’s own account, distinguishing it from traditional loans.

Defaulting on a 401(k) loan carries significant consequences. If repayments are not made according to the terms, or if employment ends before the loan is fully repaid, the outstanding balance can be treated as a taxable distribution. Many plans require full repayment of the loan if employment terminates, often by the tax filing deadline of the following year. Failure to meet this deadline results in the outstanding balance being considered a “deemed distribution,” which has tax implications.

Understanding 401(k) Withdrawals

A 401(k) withdrawal is a permanent distribution of funds from the retirement account. While generally discouraged before retirement age, some situations allow for in-service withdrawals while still employed. Most traditional withdrawals are permitted after events like separation from service, reaching age 59½, or disability.

Hardship withdrawals are permitted for specific, IRS-defined “immediate and heavy financial needs.” Qualifying reasons include:
Certain medical expenses.
Costs related to purchasing a principal residence (excluding mortgage payments, unless to prevent foreclosure).
Payments to prevent eviction or foreclosure on a primary residence.
Expenses for repairing damage to a principal residence qualifying for a casualty deduction.
Funeral expenses for a deceased parent, spouse, child, or dependent.
Post-secondary education expenses for the participant, spouse, or dependents.

Hardship withdrawals are limited to the amount necessary to satisfy the immediate need and cannot be repaid to the plan. The funds are permanently removed from the retirement account, reducing future growth potential. A plan administrator determines whether an employee’s situation qualifies for a hardship withdrawal and may require documentation.

Tax and Penalty Implications

Accessing 401(k) funds through either a withdrawal or a defaulted loan triggers tax and penalty consequences. All withdrawals from a traditional 401(k), including hardship withdrawals, are subject to ordinary income tax. This is because contributions to traditional 401(k)s are made with pre-tax dollars, and the earnings grow tax-deferred. The amount withdrawn is added to one’s taxable income for the year, potentially pushing them into a higher tax bracket.

In addition to ordinary income tax, distributions made before age 59½ are subject to a 10% early withdrawal penalty, as outlined in Internal Revenue Code Section 72. Several exceptions exist to this 10% penalty, though income tax still applies. These exceptions include:
Total and permanent disability.
Substantially equal periodic payments (SEPPs).
Qualified domestic relations orders (QDROs).
Unreimbursed medical expenses exceeding 7.5% of adjusted gross income.
Distributions to qualified military reservists called to active duty.
Certain emergency personal expense distributions up to $1,000 per year (as of 2024).
Distributions for victims of domestic abuse up to $10,000 or 50% of the account.

A defaulted 401(k) loan is treated as a taxable distribution. The outstanding balance becomes subject to both ordinary income tax and, if the individual is under age 59½, the 10% early withdrawal penalty. This combined financial impact of income tax and penalties can substantially reduce the amount received and negatively affect long-term retirement savings. For instance, a $25,000 withdrawal could result in thousands of dollars in federal income tax and an additional $2,500 penalty.