Should We Use Retirement Savings to Pay Off Credit Card Debt?
Someone experiencing financial and personal hardship may need to consider various options of staying afloat and ways to pay the bills. The option of using retirement savings, specifically from a 401k, to repay your monthly payments for your credit card debt may come up.
What are the implications of such an option?
Many experts would agree, that steering clear from withdrawing early from your 401 is ideal. However, life predicaments may put us in a less than ideal financial position where all the options may need to be considered, especially when it comes down to survival; keeping food on the table and roof over one’s head. (If this is the case, it’s important to get help. This option can only be a temporary band-aid and for most people may not be sustainable)
Before considering the ultimate no no of making an early withdrawal and getting hit with a 10% fee in addition to the taxes owed on the withdrawal, some may have an option to borrow against their 401K money. (not all 401K’s have this option).
What are the drawbacks, the disadvantages, both short or long, in taking out a loan from your 401k?
There are two immediate implications involved.
You lose out on the tax deferred growth of your 401k retirement account. (Or of the amount you borrowed).
You may not be able to contribute additional funds to your own 401k account.
In an example where one may need to make an early withdrawal in order to payoff a growing credit card balance with high interest rates, there still may be what to be gained.
Let’s consider why taking money out from your 401k may be a good idea in this situation.
First, since the person is below the 59.5 age, there will be a 10 percent penalty on the withdrawal. You also will have to pay the income tax on it. Keep in mind, however, that the 10 percent withdrawal, is a one time fee.
Let’s consider the high interest rates from the credit card,(probably higher than 10%) and then compare that to the 10 percent (one time) interest of the withdrawal. Most likely, it’ll be lower, so the tradeoff here may be beneficial.
According to Market Watch Retirement Columnist Robert Powell’s article “That 401(k) loan may cost more than you realize”, between 1 in 5 and sometimes even 1 in 4 people that have a 401K loan option utilize the option.In a 2011 study, Harvard Business School Professor, John Beshear, explained that some credit card interests may be as high as 30 percent. He claims that in a case similar to our example, when taking funds out of a 401k, the person will probably pay a much lower interest rate on the 401K loan than on the high interest growing credit card balance. In the event that you do take out a 401k loan, the other benefit, according to Beshear is, that the principal and interest payments you make on your 401k loans go right into your 401k account. (although one should still be aware is that the funds used to make such a loan payment are from post tax funds. This has a double impact. The funds going back into the 401K are being double taxed; once now while making this payment and when the funds come out in retirement).
A few things one should consider prior to pulling money out of their 401K, or committing to a 401k loan is:
Can you make the loan payments in time? Let’s say you lose your job, or you quit, 401k repayments must be paid within 60 days. If you keep your job, and aren’t fired, you still have to worry about meeting deadlines or else the 401k loan will be treated like an early withdrawal, and you’ll be taxed at your current tax level plus the 10 percent penalty. (Wowzers)!
Do you qualify for a personal loan? Since you’ve been paying off this credit card debt, and let’s assume on time, you may qualify (depending on your credit score) for a personal loan, where the interest rates are fairly low and friendly. This will give you an easier time paying back your credit card debt, but also you’ll have more time in doing so. With this option, will save you from dipping into your savings or retirement.
Could you find a different credit card company to transfer your balance over to and pay an introductory rate of zero percent? There are companies out there with zero percent introductory rates, and they keep that rate for up to 18 months. This gives you time to pay off the loan before the interest kicks in.
Can you consolidate your debt? Try to negotiate a much more friendly rate for you to pay off that debt. Credit card companies are in the business of making money. In many cases the companies may be open to working with you to come up with a plan. Be careful from companies that claim to fix debt issues. Check their reviews, and read the fine print. (I heard of one story where someone signed up with a company that committed to helping the person negotiate terms and their balance. They were under the impression that this company was handling their payments and would communicate with the company to negotiate on the person’s behalf. Essentially the company allowed the person to fall further into debt and allowed so much time to pass that their credit rating was severely impacted for years to come. And then that company used this new dire credit situation to negotiate with the credit institutions. After all, who wants to keep a toxic account on their books…I am not a fan of such tactics).
The Final Words
Frankly, withdrawing funds early or taking out a loan on your 401k is typically frowned upon and for good reason:
it’ll affect your overall retirement and
there are penalties and taxes involved in doing so.
However, things do happen, and although not ideal, sometimes one may need to exercise these options. As long as your 401k allows you to take out a loan, the trade-off may much more beneficial than getting buried under high interest rate balances. (Of course, make sure to seek advice from a financial professional).