When it makes sense to dip into retirement savings to pay off credit card debt
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With credit card debt on the rise, as US budgets are squeezed by inflation and interest rates rise, many people may be eager to find ways to reduce their balances.
One place they can check is their retirement accounts — and specifically their 401(k) plan.
Many people have the majority of their savings in these plans because their employer automatically enrolled them. In some cases, their company also matches their contributions as an incentive.
There are generally three ways people can dip into their workplace retirement savings to cover a credit card bill. You can withdraw from your 401(k), borrow from the account, or put your contributions on hold for a while and redirect the extra money to your plastic in the meantime.
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In all these cases, financial experts have warnings.
“While I don’t like credit card debt, it’s hard for me to argue that you should withdraw your 401(k) early,” said Ted Rossman, senior industry analyst at CreditCards. com.
This is because it will cost you dearly, he said.
Why Most Should Avoid 401(k) Withdrawals
Withdrawals from 401(k) accounts before age 59.5 are subject to a 10% penalty and tax. That means if you needed $15,000, you’d need to withdraw almost $24,000, after those fees are taken into account, according to Fidelity.
Of course, that money you withdraw from the account will also miss market gains. Stocks have produced an average annual return of more than 10% over the past 100 years or so.
All of this, Rossman said, “should combine to far exceed the average credit card rate.”
However, there may be exceptions.
For people over 59½ and in a low tax bracket, a 401(k) withdrawal to pay off credit card debt may make sense because they would avoid the 10% penalty and not be subject to a huge drawdown, says Allan Roth, a certified financial planner and founder of Wealth Logic in Colorado Springs, Colorado.
“Certainly the math can be worth it,” Roth said.
For most others, however, there are more attractive options than a withdrawal, Rossman said.
“Stopping your 401(k) contributions for a while — or at least reducing — and redirecting those funds to debt repayment might make sense,” he said.
Yet this advice comes with an asterisk.
If your employer offers a business, experts recommend that you try to save at least up to a certain point, whether that’s 3% or 5% of your paychecks.
“It’s free money that often doubles your return,” Rossman said.
A loan from your 401(k) is also usually better than a withdrawal, experts say.
The interest rate on 401(k) loans is typically less than 5%, well below the annual fee of most credit cards. Interest paid on the loan also goes back into your savings rather than a bank.
“Using a 401(k) loan to pay off high-interest debt, like credit cards, could reduce the amount you pay lenders in interest,” said Jessica Macdonald, vice president of thought leadership. at Fidelity Investments.
Other benefits of a 401(k) loan, Macdonald said, are that they don’t require a credit check and they don’t show up as debt on your credit report.
401(k) loans also come with caveats
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But there are also other factors to consider here.
For one thing, you will need to be able to repay the loan within five years. You could also face consequences if you quit your job and don’t repay the loan. In such cases, your loan would be considered in default, and you would be hit with taxes and that 10% withdrawal penalty on anything you still owe. And, again, your money will miss market returns.
Anyone considering turning to their 401(k) to settle credit card balances would also be wise to think about the behavioral reasons they got into debt in the first place, some experts say.
“If someone takes money out to pay off their credit card debt and then buys more to replenish the debt, it backfires,” Roth said.