Withdrawing vs. borrowing from 401(k) to pay credit card debt
By Gary Foreman
The New Frugal You
Dear New Frugal You,
some advice. My credit card debt is becoming a problem. Ever since they cut my
hours at work, I've only been able to pay the minimum. This month, altogether
my balance is $9,700. It's been growing a little each month. I'm thinking of
making a withdrawal from my 401(k) to pay off the credit cards. I'd do it
except for the penalties and the fact that I just turned 40 so I'm starting to
think about retirement. What should I do? -- Nick
question and one that's frequently asked. With the economic recovery lagging,
many of us who are lucky enough to have jobs have nevertheless gone five years without a raise or even suffered reduced hours.
that we stashed away in a 401(k) plan looks tempting, especially when we're
struggling to make minimum payments.
let's see if we can help you decide whether to raid that 401(k) to pay off your
credit card debts.
begin by seeing what happens if you pull the money out of your 401(k) and use
it to pay off credit card balances.
money that you take out will be subject to ordinary income tax. For
illustration, we'll assume that you're in the 25 percent tax bracket (income
from $36,251 to $87,850 for single filers).
unless you qualify for a hardship exception, you'll also pay a 10 percent early
unlikely that you qualify for a hardship. According to the Internal
Revenue Service, a qualifying hardship is one in which you face
"immediate and heavy" expenses defined as: "(1) certain medical
expenses; (2) costs relating to the purchase of a principal residence; (3)
tuition and related educational fees and expenses; (4) payments necessary to
prevent eviction from, or foreclosure on, a principal residence; (5) burial or
funeral expenses; and (6) certain expenses for the repair of damage to the
employee's principal residence."
haven't said you face one of those qualifying expenses, so 35 percent of any money you withdraw will probably go to the IRS.
We'll also assume that you want to end up with $10,000 (the math is much easier
formula to determine what to withdraw is the amount of money you want ($10,000)
divided by the percentage of the withdrawal you get to keep (in this case 1
minus 35 percent = 65 percent). So $10,000 divided by .65 = $15,385.
You'll need to take out more than $15,000 from your 401(k) to pay off the
you do that the benefits are clear. You won't have that credit card balance
haunting you each month. But the costs are harder to see.
because you won't face the costs until you retire. To illustrate, we'll assume
that you were able to earn 5 percent on that money if you left it in the 401(k).
At that rate, the money would double every 14 years. So by the time you retire
in your late 60s, it would have doubled two times and would be worth about
retirement experts say that you can safely take about 3 percent of your
principal each year in retirement. So that $60,000 would be about $1,800 per
year or $150 a month for the rest of your life and still leave the original $60,000
as an inheritance for your children.
try looking at a different option. Suppose that instead of taking a withdrawal
you choose to borrow from your 401(k). Because it's a loan and not a withdrawal
you won't pay taxes on it.
there will be an interest rate applied to the loan. Check with your plan
administrator to find out what the interest rate will be.
It is likely that your 401(k) loan will have a lower interest rate than what you're paying on your credit cards. Your human
resources department at work should be able to tell you what your loan payment
will be. You can compare that to your current credit card payments.
those lower payments don't come without a risk. Generally you need to repay the
whole 401(k) loan amount if you leave your job. So you're stuck in your job
until the loan is repaid. And a layoff could be a real problem.
possibility would be to check out nonprofit credit counseling. If you qualify,
they can get a reduced interest rate and a lower payment from your card issuer for you. You can find
them through the National Foundation for Credit
Counseling or Association of Independent
Credit Counseling Agencies.
final option would be to find a way to make up for the lost hours via a
part-time job. Use the extra earnings to pay down your debts.
that might be the best option. If your expenses regularly exceed your income
you'll continue to have a debt problem. Even if you wipe the slate clean today, you'll
only start building a new balance next month, which will only return you to the situation in which you are now.
See related: Using 401(k) money to
pay down debt
For more than 35 years, Gary Foreman has worked to help people get the most for their money. Prior to founding The Dollar Stretcher.com, he was a financial planner and purchasing manager. Gary began The Dollar Stretcher website and newsletters in April 1996. Today the website features more than 6,000 articles on different ways to live better for less. Gary has been interviewed by The Wall Street Journal, The Nightly Business Report, USA Today, Reader's Digest and other newspapers and magazines. Gary answers a question about a budgeting or saving issue from a CreditCards.com reader each week.
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Published: April 25, 2013