Can I Take a Hardship Withdrawal for Credit Card Debt?

Credit card debt can put serious strain on your finances. That’s because credit card interest rates are typically much higher than with other types of borrowing. For that reason, paying down credit card balances is often a top priority when you’re trying to regain financial stability. 

When attacking your credit card debt is your highest priority, you may want to throw everything you can at it. You might even be tempted to dip into your retirement savings to bring credit card debt under control—but that strategy deserves careful thought.

The problem is, the IRS has strict rules about how and why you can use your retirement savings. So it may not even be an option. Even if you qualify, it's not always a good idea.

Still, there are debt relief alternatives that could help you conquer your credit card debt—without risking your retirement funds. Knowing what you can (and can’t) do to pay down credit card debt is an important step toward finding the right solution. 

What Is a 401(k) Hardship Withdrawal?

Some emergency circumstances allow you to withdraw money from your retirement savings. The IRS defines a hardship withdrawal as one necessary to meet "an immediate and heavy financial need." 

What does that mean? The IRS describes several situations that would qualify an immediate and financial need—but paying off debt isn’t one of them. 

Some other potential issues with hardship withdrawals to consider:

• The IRS allows 401(k) plans to offer hardship withdrawals, but it’s not required. Depending on your employer's plan rules, your 401(k) may not offer them.

• You can only take a hardship withdrawal if you have no other financial means available.

• Hardship withdrawals are generally subject to ordinary income tax. They may also incur a 10% early withdrawal penalty.

• Hardship withdrawals can’t be repaid into your plan balance. That means they’ll permanently lower your retirement savings.

In light of the above, taking a hardship withdrawal from your retirement plan to pay credit card debt is not a viable option.

IRS Qualifying Reasons for Hardship Withdrawals

Every 401(k) plan has to determine whether a request for a hardship withdrawal meets IRS guidelines. Hardship withdrawals are allowed for:

• Medical care expenses for the employee, employee’s spouse, dependents, or a beneficiary.

• Costs directly related to the purchase of an employee’s principal residence (not including mortgage payments).

• Tuition, educational fees, and room and board for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents, or beneficiary.

• Payments to prevent the eviction of the employee from their principal residence or foreclosure on the mortgage on that residence.

• Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.

• Certain expenses to repair damage to the employee’s principal residence.

Paying off credit card debt doesn’t qualify under the guidelines, so a 401(k) hardship withdrawal isn’t an option for paying off credit card balances.

This information is intended to provide a general feel for IRS guidelines, but is not intended as tax advice. Freedom Debt Relief is not staffed by tax professionals. If you're considering a withdrawal from a retirement plan, it's a good idea to first talk to a registered tax preparer or CPA. If you don't know one, use the IRS's look-up tool.

Can You Use a Regular 401(k) Loan for Credit Card Debt?

A 401(k) hardship withdrawal isn’t an option for paying credit card debt, but there could be another way of using your retirement savings: a 401(k) loan. However, a loan involves significant financial risk.

With a 401(k) loan, you borrow money from your plan balance and pay the money back over time, just as you would with a regular loan. The IRS permits 401(k) loans, but it's up to the employer to offer them. 

Loans from a 401(k) plan have specific guidelines:

• The most you can borrow is $50,000 or 50% of your vested plan balance, whichever is less.

• You must repay the loan within five years, unless the purpose of the loan is to buy your principal home. 

• Any part of the loan that isn’t repaid is considered a plan withdrawal. That means it may be subject to ordinary income tax, and possibly a 10% early distribution penalty.

• If you leave your job for any reason, your loan could be due in full.

These potential tax consequences could hit you unexpectedly. Starting in 2018, the deadline to repay a loan when you leave your job is the due date of your federal income tax return.

Depending on when you leave, you might have to meet an accelerated repayment schedule just when you've lost your paycheck. If you can't do it, you could face taxes and a 10% penalty on the amount you can't repay on time.

Even if you do repay your loan, borrowing against your 401(k) is almost certain to have long-term consequences. Until you repay the loan, that money can’t earn any investment returns. This would hamper the long-term growth of your retirement assets. Also, having to repay the loan may diminish your ability to make new contributions to the plan, further reducing the growth of your nest egg.

People are often anxious to pay off credit card debt because it's so expensive. Still, borrowing against your 401(k) plan can also cost you dearly.

Consequences of Early Retirement Withdrawals

Whether you take a hardship withdrawal or borrow against your 401(k) plan, there's likely to be a cost of withdrawing from your retirement savings early.

In the case of a hardship withdrawal, the money you take out can't be replaced later on. That's likely to reduce your retirement savings by more than just the amount you take out. You'll also be missing out on the compound investment returns that money would have earned in future years.

Suppose you take money out 25 years before you retire. At a 7% return, a dollar invested in the plan would grow to about $5.43 in 25 years. That means every dollar you take out 25 years early could reduce your balance by $5.43 by the time you retire.

On top of that cost, you may have to pay a 10% tax penalty on your withdrawal. In a traditional 401(k) plan, you'd also have to pay income tax on the withdrawal. Yes, you'd probably have to pay income tax on withdrawals eventually. However, incurring that tax during your career could mean paying those taxes while you're in a higher tax bracket than you'll be in retirement.

Some of this impact is felt even if you take out a loan and then repay it. You'd miss out on compound returns until the money is repaid. Making payments on the loan might reduce the amount you can afford to contribute to the plan. That would cause you to miss out on those contributions and the investment returns they could have earned. Also, if you fail to repay the loan, you'd add tax consequences to the cost.

Bottom line: Using retirement savings to pay off credit card debt is rarely cost-effective

Alternatives to Hardship Withdrawals for Credit Card Debt

Given that hardship withdrawals and 401(k) loans are not good options for paying off credit card debt, what other choices do you have?

There are other ways to bring your credit card debt under control. Here are some options you might consider if you're struggling financially. 

Debt settlement

Debt settlement is the process of negotiating to have a creditor accept less than the full amount you owe and forgive the rest. It's typically only an option with unsecured debt—which includes most credit card debt.

A creditor might accept a partial payment if they believe you won't be able to pay the full amount. You could attempt to negotiate this kind of settlement yourself or you could hire a professional debt settlement company to handle it for you.

Settled amounts might be subject to income taxes, though this may not be the case if you're insolvent. Also, a debt resolution professional will charge a fee. A legitimate debt resolution company won't charge any settlement fees until you've agreed to a settlement and at least one creditor payment has been made.

Even with these potential costs, you may find that debt settlement is cheaper than having to pay the full amount that you owe.

Debt management plans

A credit counselor from a nonprofit credit counseling agency can put together a debt management plan (DMP) for you if you qualify. Under a DMP, you’d make one monthly payment to the credit counselor and the counselor would then distribute the money to your creditors.

A DMP could do more than just simplify your payments. Your credit counselor might be able to negotiate more favorable payment terms, including lower monthly payments, delayed payments, fee waivers, or reduced interest rates.

A DMP doesn’t reduce the amount you owe, and it will also have some fees. Have a detailed conversation with a credit counselor before you commit to a DMP. Have the counselor explain the specific ways the plan might make your debt more manageable. 

Hardship assistance

Some credit card companies are willing to work with you if you're having trouble paying your bills. They might figure out a payment plan that will allow you to eventually pay what you owe.

It helps if you can explain that you've had a temporary financial setback that was beyond your control. Also, have a plan for how you'd pay your debt in the long run. 

To make this possible, a credit card company might be willing to give you a break on payment terms, such as waiving fees or reducing interest rates. They may also agree to reduce or delay payments. 

Credit card companies don’t generally advertise this kind of help. Contact your credit card company directly, explain your situation, and find out what kind of help they're willing to offer. The sooner you contact them, the more options you'll likely have.

Bankruptcy

If you have unmanageable credit card debt and few assets, bankruptcy could be a solution to consider. The two major types of personal bankruptcy are:

• Chapter 7 bankruptcy. Also called liquidation bankruptcy, Chapter 7 involves selling off your non-exempt assets to pay what you can of your unsecured debt, then the rest is forgiven. Some assets, such as retirement accounts, are protected. The court will decide how to split assets among your creditors. This could give you a financial reset within a matter of months. You need to pass a means test to qualify for Chapter 7 and you may not be eligible if you make too much money.

• Chapter 13 bankruptcy. Also called restructuring, Chapter 13 looks at your income and expenses to work out a payment plan with your creditors. The court decides where your money will go. This can last for three to five years, but you won't have to sacrifice your assets. This could be the better option if you're facing foreclosure.

Certain rules determine which type of bankruptcy you’re eligible for. You’re likely to have to sacrifice some income or property in a bankruptcy. There will also likely be a long-term impact on your credit. Consult with a bankruptcy attorney to decide what makes sense for you.

How to Know Which Debt Solution Fits Your Situation

When handling debt, it's good to know you have options. The key is figuring out which is the right choice for your circumstances. Start by listing the pluses and minuses of your financial situation. 

The pluses include:

• Income. Look at how much you take home after taxes and other deductions. Also include any other income, such as government benefits, spousal support, pension payments, etc.

• Assets. This includes both bank accounts and other financial assets. You might also have personal property you could sell to pay off debts. Think twice about including any retirement amounts, given the cost of taking early withdrawals.

The minuses include:

• Monthly expenses. This includes your debt payments plus anything else you regularly spend money on. Make a note of which of those expenses are absolutely essential, and which you could live without for a time.

• Debt balances. Total up what you owe, and make a note of which debts are secured and which are unsecured.

Consider anything you could do to increase the pluses and reduce the minuses. Find out if it's at all possible to get your monthly expenses down below your income. Also, check whether debt balances can be reduced below the value of assets you could easily liquidate.

In this way, you can decide whether there’s any way you could meet your debt payments. If not, you might have to consider a solution that reduces the total amount you owe. This might mean debt settlement or bankruptcy.

If you don't feel comfortable making this decision, consult with a financial professional. Detailing your financial plusses and minuses could give you a good basis for that discussion. Freedom Debt Relief can give you a free assessment of your situation. 

The main thing is to take action. The fact that you’re reading up on strategies is a positive step that could bring you closer to a successful plan for your debt. Having a plan could put you on track to break the cycle of debt. Not only that, you may even start feeling better about your situation once you've made a decision.