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Don't use 401(k) to pay off credit card debt

Pay it and cut back to 3-day work week? Only if you want to work forever

By Gary Foreman

The New Frugal You
New Frugal You columnist Gary Foreman
Gary Foreman is a former financial planner who currently edits The Dollar Stretcher website and newsletters. He writes "New Frugal You," a weekly Q&A column about frugal living, for CreditCards.com

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Question for the CreditCards.com expert

Dear New Frugal You,
If I could pay off my credit card debt, I could manage a three-day work week. Would it make sense to withdraw enough from my 401(k) to pay this off?  -- Judy

Answer for the CreditCards.com expert

Dear Judy,
Think of the credit card debt as being in your left pocket and the 401(k) account in your right pocket.

Over on the left pocket, you need to make at least a minimum payment on the credit cards each month just to keep it from getting heavier. That payment must be substantial since you need to work two days each week to cover the debt.

While all this is happening in the credit cards pocket, over in the right pocket, the 401(k) is is starting to bulge as you add to it, it earns interest and the portfolio gains value.

I'm sure it seems a simple answer to your debt problem: Just take money from the bulging 401(k) pocket and put it in the other to wipe out the credit card debt.

But due to tax implications and special rules for early withdrawal from 401(k)s, it's almost never a good move. That's because for every dollar of debt that you wipe out, an even greater amount of retirement income disappears with it.

Let's see why. First, there's that early withdrawal penalty. If you're younger than 59 1/2, you'll pay a 10 percent penalty on every dollar withdrawn.

Next, because of the income taxes involved, any money withdrawn is considered ordinary income for tax purposes, and you'll be taxed at your regular tax rate. Depending on your tax rate, that means you've immediately lost a quarter to nearly a half of its value.

Finally, you lose the opportunity to let the investment grow. Every dollar will be worth more by the time you retire. Depending on your investment return, a dollar today could double every 10 years or so. 

Bottom line: Sure, you can take money from your 401(k) and pay off your debts. And that might even let you cut back to a three-day work week. But when it comes time to retire, you'll be missing all that money that should be in your 401(k) account. In effect, you drop a lot of money when you shift it between pockets  -- and sentence yourself to working many, many more of those three-day weeks.

A better plan is to continue to work a five-day week -- and maybe even ramp up and find more ways to enhance your income. Use the extra money to repay those debts as soon as possible. Once they're repaid, you can decide whether you want to reduce your work schedule without fear of hurting your own retirement.

See related: Debts and how to handle them, Alternatives to using 401(k) for debtWhen must you start to make 401(k) withdrawals?

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. Send your question to The New Frugal You.

 

Published: August 5, 2010



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