Don't retire card debt with 401(k) savings
The cost far outweighs the benefits
To Her Credit
Dear To Her Credit,
I have about $30,000 in high-interest credit card debt. I have about $83,000 in a 401(k) plan from a past employer that I can no longer contribute to and about $10,000 in a current 401(k) plan to which I contribute between $6,000 to $7,000 a year.
I am thinking of taking an early withdrawal from the old 401(k) plan to pay off the debt. It would save me about $650 in payments every month, some of which I would funnel to the new 401(k) plan. Is that a good idea or bad?? I am not 59-1/2 years old yet. -- Kathy
I am usually in favor of paying off credit card debt with savings -- especially when the interest rate is much higher on the credit card balance than you are earning on savings.
However, retirement accounts should be for retirement. Not so long ago, more people worked for one company most of their earning years and qualified for a pension when they were done. Now, you're more likely free to make your own retirement contribution and investment decisions -- but with freedom comes responsibility. If you don't save and keep on saving for your retirement, no one will.
Another problem is that to pay off $30,000 in debt, you'll have to take much more than that out of your 401(k) plan. In order to cover income taxes and the 10 percent penalty for early withdrawal, you may have to withdraw about $46,000 -- more than half the balance of your old 401(k) plan. It could take you six to eight years to get your retirement account balances back up to where they are now.
Some people discover when they use home equity loans, debt consolidation loans or retirement funds to pay off credit cards, the credit card balances start creeping back up again. It's easy to say that would never happen to us, but unless the habits and circumstances that got us into debt in the first place have changed, it's all too likely.
Instead of decimating your retirement fund to pay off credit card debt, take these steps:
- Make a list of your debts, including interest rates and minimum payments.
- Make a budget based on what you make and spend right now, including credit card payments and 401(k) contributions.
- Find ways to reduce your interest expense, such as transferring the debt to lower interest cards or asking the banks for lower rates.
- Consider reducing additional 401(k) contributions until you pay off your credit card debt.
- Find more money to apply to debt payments; for instance, you can sell something, work overtime, start a side business, lower your income tax withholding (if you usually get a refund), or collect on that loan you made to a relative years ago.
- Look for creative ways to cut expenses. Cable, cell phone service, lawn care services, magazine subscriptions and salon manicures are all candidates for being cut. Compare car, life, home, health and umbrella insurance rates every year. Cook from scratch.
- Pay off cards one by one, starting with the ones with the highest interest rate. If two cards have the same rate, pay the one with the lowest balance first.
- For more help looking at your options, see a reputable credit counselor.
Paying off your debt without dipping into your 401(k) plan may seem hard, but it's the best way in the long run. The skills you learn as you climb out of debt will help you stay in control of your finances the rest of your life. Take care of your credit, and your retirement!
See related: Debt can slow down retirement goals, When credit card debt ruins retirement, Establish retirement priorities when paying off debt, Emergency fund, retirement, come before credit card debt
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Published: July 23, 2010
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