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:
photo credit: cncpt
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:
- 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.
- 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.
- 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.
- 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.
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.
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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.
Motley Fool made just the opposite recommendation in the article
9 Ways to Pay of Debt based (I gather) on the fact that the interest rate on the loan is lower than the interest rate on the credit cards. Based on their article, I went ahead and took a loan on my 401(k).
I’m just curious how you would respond to their argument?
Thanks!
Deb´s last blog ..T -29 Days to a $0 Visa Balance
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.
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.
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.”
Wojciech @ Fiscal Fizzle´s last blog ..Saving More vs. Insuring More
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.
…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.
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!
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.
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.
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!
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!
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.
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.
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.
DebT´s last blog ..Credit Card Debt Solutions
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?