4 Reasons You Should Not Use Your 401k to Pay Off Your Credit Card

by Joe Plemon on June 19, 2012

Q:  We have $30,000 in credit card debt and it seems it will take forever to get it paid off.  Should I use money from my 401(k) to pay off that debt?  I am 35 years old.

A:  I realize, when you see that money sitting in your 401(k), that there is a temptation to tap into it so you can make that credit card debt disappear.  I also realize that it seems to take forever to make progress on your credit cards, especially if all you are paying is minimum payment.  But using your 401k money to pay off credit card debt is not a good option for several reasons.  Here are four:
Use 401k to pay off credit cad debt

1. Taxes and penalties.

Because a 401(k) is a pretaxed investment, you were able to save taxes for all of those donations.  However, your Uncle Sam keeps records and will want his money back whenever you decide to tap into them.   Also, because you are younger than 59 1/2 years old, you will be required to pay a 10% penalty on whatever amount you take.  So, the taxes (about 25%) and the penalty (10%) would cost you $46,000 to pay off the $30,000 credit card debt.  It is like paying 35% interest on a loan.  Bad idea.

2. Money Stops Working For You

But it is really worse than that because now the money would not be working for you.  That $46,000 used to pay off $30,000 worth of debt could potentially be worth over a million dollars in 30 years.  You have worked hard and sacrificed in order to build up your 401(k), so don’t compromise your retirement over a credit card debt.

3. You wouldn’t be dealing with the real problem.

You need to ask yourself, “Why do I have this credit card debt?”  Whatever behaviors created the debt need to be eradicated from your life and you need to go forward with a resolve to never go back.

4. You need to attack the credit card debt.

Yes, this will take time, but once you develop a plan, you will be surprised at how much progress you can make.   These tips will help:

  1. Budget Time. You must create a personal budget so you can understand your cash flow and find ways to make extra payments on your credit card debt.
  2. Stop Contributing. Until you are out of debt, you should temporarily stop your 401k retirement investing or at least cut back to the minimum amount you can invest in order to get your company match.  Think about it:  keeping debt around while you are investing is the same as borrowing money to invest with.  Once your debt is gone you will have more money than ever to invest.
  3. Get a second job.  This is not for the rest of your life, just long enough to pay off your debt.  If your minimum payments on your credit card debt are currently $1,000 a month, an extra $1,000 a month will all go toward the principle and will drastically reduce the time it will take to get it paid off.
  4. Set a time goal.  If you follow these first three tips, it is not out of reason to see that credit card debt disappear in 12 to 18 months.

Creative Commons License photo credit: cncpt

The most important thing you can do is to change the habits that created the credit card debt.  Don’t sacrifice your future for a quick fix.  Instead, make huge sacrifices now and use a budget planner so you can get this debt out of your life forever.

email

{ 29 comments… read them below or add one }

Wojciech @ Fiscal Fizzle July 13, 2009 at 7:51 am

I agree that I would never touch a 401(k) to pay down anything. However, I would consider taking some money out of a Roth IRA (the contributed amount only, to avoid penalties) in certain cases. I can think of one good example:

You buy something on credit with deferred interest for one or two years. If you pay it off within that time period, fantastic – it’s interest free. If you don’t, the entire two years of interest gets tacked on, sometimes to the tune of thousands of dollars!

In that case I would consider using those savings to pay down the debt and then aggressively replenish the funds.

Reply

Joe Plemon July 15, 2009 at 2:00 pm

Deb
Yes, you can save some interest by borrowing from yourself, but Motley lists several drawbacks. In general, I don’t like the risk of knowing that the entire loan comes due if I leave employment (or in five years). Worst case scenario: a married person takes out the loan, then dies unexpectedly. The surviving spouse has not only lost that income stream, but now has to figure out how to pay all of the money back or else pay taxes and penalties.
I like to keep my finances simple and avoid risk whenever possible.

Reply

Joe Plemon July 15, 2009 at 2:17 pm

Wojciech,
As the risk of sounding snarly, the scenario you described would never occur if you always save up and pay cash instead of buying anything on credit. As you aptly described, the “24 months same as cash” loans are time bombs ready to ignite.

Would I advise someone in that situation to tap their Roth IRA in order to avoid those two years of interest, penalties, etc? Hmmm. Maybe, if I thought they had sufficiently learned the lesson to never borrow money again.

Reply

Wojciech @ Fiscal Fizzle July 15, 2009 at 2:38 pm

Joe,

I agree – cash up front is my preferred choice as well. It always seems like you plan and plan and figure out a way you’re going to pay down everything right on time, and then a month after you get going, something changes – your income, expense situation, whatever, and the loan lags and lags until you get hit with penalties and interest.

So yes, I echo your sentiment and hail “cash is king.”

Reply

J. Money July 22, 2009 at 3:42 pm

WOW. I’m glad that person wrote in!! I 100% agree to stay away from your 401k. It’s actually #9 on my recent “best order to take out money” (excuse me for linking over) right below payday loans! haha….

Let that 401k sit there and continue growing.

Reply

janet September 23, 2009 at 8:00 am

…but but…..because of a few distracting factors it completely got by us that we are now being charged 19.99% interest on our highest balance credit cards. Our credit score is excellent and the CC company said “sorry, do what you have to do” when I told them that I will close the account this week. We have been approved for a platinum MC at a lower fixed rate through our FCU but we have to combine a previous card, and that would create a “maxed out” situation. We feel as though a 401k loan is our only option. We are confident that we have put ourselves in good position to remain at low debt-to-income ratio after this move.

Reply

Marc September 23, 2009 at 4:01 pm

I read over and over that borrowing from a 401K is a bad idea. I understand the pitfalls, however, I think there are situations where it can make sense. First of all, many say I’ll miss out on “Opportunity” of the borrowed money. Well, what about the negative “opportunity”, such as in 2008 when I saw my 401K go from about $300K to $175K, man, did I wish I borrowed that money then to keep it out of the market. So, in the lovely bull market of 2009 much of my money is back in the 401K, so I’ve borrowed $30K, at 3.25% for five years to pay off $23K in debt (fixed at 5%) and also have some left over ($7K). All the articles I’ve ever read indicate the problem with losing a job and still having the 401K loan outstanding, but most articles don’t mention what will happen to me if I lose my job and I still owe $23K to credit cards. I would honestly rather default on my 401K loan, and pay say a $10K penalty, which would probably come out of the remainder of my 401K (still plenty left), than default on my credit cards and never have good credit again, watch my interest rise from 5% to 25%, and be beholden to the banks forever. Then it would be too late to reach for my 401K (if no job). So I’d rather do it now when I can. Also, taking out an additional $7K and putting it in a savings account (yes, very low interest at best) at least gives me some cash to reach for if I were to lose my job so I can have a little cushion, a very little one, to make some subsequent grim decisions moving forward or hold me over. Right now I have $300K in 401K, but not much other savings so if I lost my job I’d be screwed by the end of the month. Yes, I have to be extremently careful and change my habits and not spend that additional $7K, but that is no different than with spending on a credit card. (Incidently, the cc debt was $26K a year ago, so I have made progress and going in the right direction). Another benefit of going with the 401K loan is I’m immune from the credit card companies raising rates unexpectedly, and doing some other scary things that I’ve been reading about. And yet another benefit that goes unmentioned often, is theoretically my credit score should skyrocket (already 790 though), thus some day enabling me to get a better refinance on my large california mortgage. And the last thing that I just don’t understand is the “you’ll be taxed twice” argument. Yes, it is a true statement, unarguable. But paying off my credit card with my salary is also “after tax” money, and a dollar is a dollar, so how is that different than paying off my self loan with after tax money? Anyway, maybe I’m missing something, but I don’t think all situations are equal and it very well could make perfect sense. Hope so, because it is exactly what I am doing. Thanks for reading!

Reply

Joe Plemon September 24, 2009 at 8:28 am

janet,

Aren’t CC companies great? They can be ever so sweet until they get their hooks into you and then their true nature (bloodsucking leaches) comes out.

You say that you feel that a 401(k) loan is your only option. Maybe so, but here is where I am coming from: personal finance is much more behavior than math. I would become radical about getting my CCs paid off as soon as possible and then get them out of my life forever. Radical means second job (temporarily), forgoing vacation, no eating out, selling an expensive car, etc. These sacrifices will change your behavior forever so you will never ever find yourself in the clutches of creditors.

I just don’t like the mindset of tapping retirement funds because of debt. Doing so could become a habit and such a habit could jeopardize your retirement without dealing with the real issues of why you are in a position to need that money.

I thank you for reading and I hope that, your way or my way, you can become debt free and move toward a great retirement.

Reply

Joe Plemon September 24, 2009 at 8:47 am

Marc,

You have put much thought into your comment and have given some compelling reasons for dipping into your 401(k). My response is somewhat the same as I gave to janet…personal finance is more about behavior than math.

Of course you have already made that decision, so I am hoping that you will become radical about paying back your 401(k) and while doing so, avoid new credit card debt like a plague.

Once you have the $23K paid down, I think you should set aside $1000 or $2000 for emergencies and then quickly pay off the $7000. After that, take the money you were using to pay off the 401(k) loan and either pay off any other debt (except your house) or quickly build up your emergency fund with savings. Do all you can outside your 401(k) to avoid the allure of tapping it (or credit cards) in the future.

Thank you for reading and for writing. I truly appreciate your thoughts and wish you the best as you work toward becoming debt free altogether.

Reply

Stephanie March 10, 2010 at 4:20 pm

Hi there,

I lost my job last year with $12,000 in my 401K. Six months later and a whole bunch of credit card debt, I have a new job and am trying to get back on my feet. I received my 401K rollover/lump sum paperwork in the mail yesterday, and I’m seriously contemplating taking out the $12,000 and paying off the debt. I’ve enrolled in the 401K program at my new place of employment. Is taking the lump sum a bad idea? I’m 28-years-old and don’t want to regret my decision when I’m 65!

Thanks for your help!

Reply

joeplemon March 11, 2010 at 10:06 am

Stephanie,
I realize that losing your job can create real hardship and debt, but using the $12,000 from your 401(k) is not the best way to get rid of your credit card debt. You are wise in thinking about the impact this could have later in life. If the $12,000 only earned 8% annual return, it would be worth about $230,000 when you retire…if you don’t add anything to it.

I want to encourage you to attack this debt. Follow the steps I suggested in this post: make a budget, temporarily stop contributing to retirement, get a second job and set a time goal.

The easy way – cashing out your 401(k) – is not the best way. However, by getting rid of your debt through hard work and sacrifice, you will keep you retirement plans on track and develop great money habits that will stick with you for the rest of your life. And, when you are retirement age, you will have no regrets.

One more thing: once that debt is gone, continue your focus by building a great emergency fund. Then, if you should lose a job, you will be prepared and won’t need to create credit card debt.

I wish you the best. Thanks for writing!

Reply

BIGSeth April 19, 2010 at 1:59 pm

Good advice telling people to stay away from 401k loans in general. However, you should really review section 1 – Taxes and Penalties. It’s just plain wrong.

Reply

joeplemon April 20, 2010 at 1:11 pm

Big Seth,

Thanks for the encouragement on the overall advice of this post. I reviewed section 1 and would appreciate more details in exactly how it is “plain wrong.” Thanks.

Reply

DebT July 16, 2010 at 1:52 pm

That’s good advice. I was thinking about possibly using my 401k to pay off some of my highest interest rate cards, but I guess it really doesn’t make sense to do it this way. Thanks for the help.

Reply

joeplemon July 17, 2010 at 7:39 am

DebT,
I am glad this post helped. Do you think the tips in point 4 (Attacking your credit card debt) will work for you? I challenge you to give it a try?

Reply

michael @ credit cards October 17, 2010 at 4:12 pm

Yeah, they are all right, you must stay away your 401k to pay your credit card debt. I too have learned something by reading all the comments and the 4 reasons why not and opened my mind for the possible ways of getting credit card debt free when I aged.

Reply

joeplemon October 18, 2010 at 10:09 am

Michael,
I am glad that the post and comments helped. Wishing you well as you work on that credit card debt.

Reply

CKinTX May 2, 2011 at 7:53 pm

Ok, so what if I don’t want to take out a loan on my 401K? I already practice the snowball effect and we give the minimum amount to our 401k – essentially whatever is being matched by our jobs. We have about $66,000 in revolving CC debt. We could use our 401K to eliminate that debt and be left essentially with only our mortgage payments and my school loan. With all this debt eliminated we could max out our 401k’s going forward at 15% each (we only give 5% now). It would also help come tax time as our taxable income would be lowered considerably if we give the 15%. We would also be able to give additional money to the IRA allowing our 401K to grow at a much more aggressive rate while being virtually debt free. I also realize if we take that much out we will likely be penalized at about $30,000 for this year. My question is, couldn’t this all be offset in some twisted way to work in our favor while getting virtually debt free? I don’t want to borrow, I just want to drain it and use it pay off the debt altogether. The CC debt was created due to losing my job and being out of work for an extended period. We are followers of Dave Ramsey and have been chopping away slowly but would love to start really charging after our retirement but at 5% per person it’s not really getting where we need it as quickly as we’d like. I just feel like if we can get rid of all our revolving debt we could begin really growing our 401K at break neck speed. Thoughts?

Reply

joeplemon May 4, 2011 at 10:36 am

@CK in TX,
Let’s run some numbers based on the following assumptions:
1. You would need to withdraw $100,000 from your 401k to pay off the $66k in credit card debt.
2. You are 30 years from retirement.
3. Your combined annual income is $50,000, which means you are contributing $2500 annually (5%) to your 401k plans and receiving a 100% match for those contributions, effectively giving you $5000 annual contributions.
4. Over that 30 year period, your investments will earn an 8% annual return.

Based on these assumptions,

If you continue what you are doing, your retirement nest egg will be about $1.7 million in 30 years. However, if you draw out the $100,000 and start anew with 15% investments (earning 100% match on your first 5% and zero match on the next 10% contribution), you would be effectively investing $10,000 annually. With an 8% return, your nest egg would be worth $1.2 million in 30 years, meaning that withdrawing $100K today is a $500,000 mistake.

It is actually more than that because you WILL eventually get that credit card debt paid off and bump up your investment contributions, thus increasing that $1.7 million you would have if you only contribute the 5% for the next 30 years. For example, if you paid off the credit card debt in five years and bumped your retirement investments to 15% at that time, (although I would recommend a big emergency fund before increasing your investments) your nest egg in 30 years would be about $2.1 million…$900,000 more than if you pulled the $100,000 from your 401k today.

I realize that the money in that 401k is tempting, but I urge you to leave it alone. One of you might consider a second job just long enough to pay off that credit card debt but even if you don’t get it paid down for a long time, your retirement will be more solvent by leaving your contributions in the fund instead of tapping what you have worked so hard to build up.

I also realize that I made some huge assumptions, but the results would be very similar even if the specifics changed considerably.

Please write back. Feel free to ask questions and let me know if what I have said makes sense.

Reply

Adam W. Prillis August 1, 2011 at 3:45 am

Folks, I would say that the credit card debt might the worst form of debt out there, it just goes on and on.

Reply

Glenn November 1, 2011 at 9:42 pm

seperated…had to get my own place, ran up CC debt on furniture, appliances, etc. Sitting here with 30k CC debt. Take home pay of 5600/mo. Expenses…$1400/mo for kids…$700/mo for kids tuition. $400 for 529 plan for kids…..$1000/mo for rent…$400/car payment(travel alot for work and need reliable car so cutting this is not an option)….$150/stu loan (min payment). $150/mo car insur….gas covered by company…..food and other utilities vary each month….now I turn my eyes towards the 30K in CC debt with less than $1000k a month to puts towards it…and my eyes keep wandering over at my $125k 401k account. I make enough to start paying down the CC debt slowly…but I am leaning strongly towards a loan with 3.8% interest. On the fence…I am secure in my job (for sales) ..dont have to worry about lay offs as long as I perform and I have performes for 8 years now.

Looking for someone to tell me why a 40qk loan is a bad idea in my situation.

Reply

joeplemon November 9, 2011 at 10:53 am

Glenn,
If you pay $1000/month on that credit card debt (at 15% APR) you will pay it off in about 3 years. Are you on a written budget? You listed $5600 take home pay and $3800 of monthly set expenses. I realize you need to eat, but if you could find a way to increase that payment to $1500 you could pay the CC debt off in less than two years. Most of your numbers seem reasonable, but I would consider stopping the $400/month 529 plan for your kids until this debt is paid off. At that time, with around $1,400 positive cash flow, you could hit it hard.

Also: if your credit score is good, you could possibly find a credit card company to agree to a 0% interest transfer for up to 18 months. Yes, there will be a transfer fee, but it would could be well worth it.

Bottom line: borrowing from your 401k might work for you, but I would seek other ways to pay off the credit card debt first. The risk is that you could lose your job before getting it paid back, which will make it all come due at once and therefore kick in penalties and taxes.

I wish you well as you are going through a tough time.

Reply

Emily Morgan @ Cash Advances US January 20, 2012 at 1:16 am

If you borrow money from your 401(k) plan, most plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn’t have this provision, it is unlikely that you can afford to make future contributions in addition to servicing the loan payment. Because the whole point of having a 401(k) plan is to use it is as a way to save for the future, you are defeating the purpose of having this account if you use it before you retire.

Reply

Joe Plemon January 20, 2012 at 4:33 pm

Emily,
Great comment. People will twist logic in all manner of ways to justify borrowing from their 401k, but in the end, they are (as you say) defeating the purpose for having it. My hunch is that most who tap into their 401k accounts will eventually regret their decision.

Reply

Tony February 11, 2012 at 9:10 am

I just took out an 10,000 loan from my 401(k) to repay some CC debt. I have about 26K in CC debt now. The loan interest is 4.5% while the credit card debt I am taking out is at 20-30% interest generally. I structured the loan to be repaid over 2 years, and I anticipate just paying one year of the amortized payments and paying the rest off in a lump sump in March 2013. I currently max out my 401K (17,000 for 2012), so I will get back that value in my 401(k) quickly anyway (the 401K increases in value by about 1,200 a month when employee match is taken into account). I will be paying an incremental $500 a month to repay the CC loan, but that is doable given my I got a $1000 a month raise this year. I’m saving about $200 on monthly interest anyway by taking out the CC debt. I will use the $500 left over for savings, investment and further debt repayment.

Honestly I shouldn’t have accrued the CC debt in the first place, but given I did (and provided I don’t run up the CC debt again), taking out the 401(k) loan is a no brainer when used to repay other, higher interest debt.

Reply

Joe Plemon February 11, 2012 at 3:55 pm

Tony,
I hope your plan works for you. Yes, mathematically, you are saving on interest payments, but you are paying for that savings in the form of additional risk…something could happen which could get in the way of paying off your 401k loan (lose your job, get injured and can’t work, etc.) This is why personal finance is called personal finance.

Myself? I would have temporarily stopped all 401k contributions above what my employer matches and applied it (along with that $1,000 pay raise) to my credit card debt. I don’t like risk.

But, being as you have already taken out that $10 K loan, I wish you the best with it.

Reply

debt help Singapore July 9, 2012 at 2:54 am

Hey, I think your site might be having browser compatibility issues.
When I look at your website in Safari, it looks fine but when opening in Internet Explorer, it has some overlapping.
I just wanted to give you a quick heads up! Other then that, fantastic blog!

Reply

Nicholas Carroll July 12, 2012 at 12:03 pm

There is also the option to simply stop paying the credit card companies. That flows into a) they probably make you a settlement offer of 50% payoff in full (which can be bargained down towards a 20% payoff), or b) simply don’t pay them anything more at all. Sure, your credit score will take a ding, but credit scores rebound fast these days, in as little as 3 years.

Moral? Probably not, in 1977 — when all 50 states capped CC rates at 9%, believing that anything higher was usury. Thirty-five years of bank abuses later, morality has changed, and I get overwhelming support from local business owners and community organizations when I assert that in 2012 morality means keeping the money in the community, and at work in the community. That $30,000 described in the first post can equal a year’s worth of employment if it is *not* paid to the CC companies.

Reply

anonymous July 18, 2012 at 8:44 pm

While in majority of cases using a 401k loan is not recommended to get out of debt, its not for all cases. when you have 30k of credit card debt all at 25%, pulling out 30k to pay all that off at 4% rate from your 401k + cuople hundred buck fee is a much better option, assuming you pay it back asap and either 1) control your habit, or 2) try to be prepared next time. Most people are not as ignorant as some would say, life can and does definitely throw us some hard big rocks. This is coming from someone who pulled such funds as life hit me w/ a tragedy, used 401k loan (no credit check, instant, low rate, low fees) and life turned around, and i paid the loan back in <6months. I'm in mid 750FICO now from high 500s, much better rates, etc… and better yet, 0$ credit card balances.

Reply

Leave a Comment

{ 22 trackbacks }

Previous post:

Next post: