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When you’re strapped for cash, it can be tempting to “cash in” on an early 401(k) withdrawal or borrow against funds in your 401(k).
The 401(k) is an employer-sponsored retirement plan that’s meant to fund your golden years. Early withdrawals or loans can be made from your 401(k), and many young adults are turning to this option.
For example, a recent survey released by Merrill Lynch found that 1 in 4 young adults with a 401(k) have already made an early withdrawal, and the top reason for doing so is to pay off credit card debt.
In this article:
- Why you should protect retirement funds at all costs
- Reason No. 1: You will most likely face a penalty
- Reason No. 2: You are taking money away from your future
- Reason No. 3: There are limits to how much you can borrow
- Reason No. 4: You may have to halt contributions
- 3 better ways to tackle credit card debt
- Bottom line
A majority of adults (60%) ages 18 to 34 believe the ultimate sign of financial success is being debt-free, according to the survey. But with burgeoning student loan debt throughout the nation and an average credit card debt balance of $3,700 per young adult, achieving financial freedom may feel like a far-off dream… unless you can tap a source of funds that should be off-limits.
Is it ever a good idea to tap into your 401(k) to clear up lingering credit card debt? We’ll offer reasons why you should avoid raiding your retirement savings, as well as provide alternative approaches to crush your debt.
Why you should protect retirement funds at all costs
Taking money from your 401(k) may seem like a perfect short-term solution to getting out of debt. The long-term consequences, of course, is that it can derail your retirement savings plan.
“You rob your 401(k) once, you’re a lot more likely to rob it again for something else later on,” said Ryan McPherson, director of coaching at SmartPath, a financial counselling company. Plus, borrowing from your 401(k) isn’t free. There are terms, conditions and fine print.
Reason No. 1: You will most likely be penalized (even more if you leave your job)
A withdrawal from a traditional 401(k) before you turn 59 ½ is usually considered an early withdrawal and taxed as income. On top of the income tax bill, there is typically a 10% early withdrawal penalty. There are some circumstances where you may be exempt from this penalty. For instance, having a disability or needing money to pay for qualifying medical expenses may make it possible for you to withdraw without the extra penalty. However, a withdrawal to pay off credit card debt is not eligible for penalty exemption.
“You rob your 401(k) once, you’re a lot more likely to rob it again for something else later on.”
Another option is borrowing from your 401(k) to pay debt instead of taking a withdrawal. A 401(k) loan isn’t a credit-based product, so you don’t need stellar credit to qualify. The interest rate may vary per plan, but it’s generally around the current prime rate plus 1%. Loan terms go up to five years and the loan is not taxed as a distribution unless you don’t pay the money back. Origination and loan maintenance fees may apply but vary. Payments have to be made at least quarterly and they may come straight out of your paycheck, depending on your plan.
Now here’s where things get tricky: The balance may become due if you resign or get fired from your job. Say you get laid off owing $20,000 on an outstanding 401(k) loan, your employer may ask you to pay off the balance. If you can’t pay it off before the end of the tax year, the distribution may be taxed as income, which can hit you deep in the pocket. Another option, if you can’t pay the loan off, is rolling it into an IRA or another retirement account.
Self-employed workers may catch a break when borrowing from a retirement plan. “If you have a Solo 401(k), you can’t quit your job and there is no opportunity for you to be terminated from that job,” said Shane Mason, co-founder of financial planning company, Brooklyn FI. There may be more flexibility when borrowing from a Solo 401(k) to pay off debt because the retirement savings isn’t tied to a specific employer.
Reason No. 2: You’re taking money away from your future
A traditional 401(k) plan is for long-term saving. You tell your employer what percentage from each paycheck you want distributed into your investment portfolio. Your employer may even match your contributions to your 401(k) as well. Then you sit back and watch as your savings compounds over several decades.
Making an early withdrawal or borrowing money from a retirement account to pay off credit card debt can bring the momentum to a halt. “Most people are behind on retirement savings in general, so it’s a bad idea to truncate your retirement savings again by taking from what you have [saved],” said Mason.
When you borrow from your 401(k), the assets previously invested have to be sold and converted to cash before its distributed to you, said Mason. Afterward, you pay back the 401(k) loan with interest. Vanguard has a calculator that can show you how much the interest costs and the impact borrowing may have on your retirement balance.
Here’s an example: A loan of $20,000 at 6.5% interest borrowed for five years from a 401(k) that earns 6.5% on average annually could lose $3,479 in missed investment returns over the five-year loan term. In comparison, a personal loan at 6.5% may still cost you $3,479 in interest, but taking out a personal loan to pay off debt leaves the balance in your 401(k) alone to continue growing.
Reason no. 3: There are limits to how much you can borrow
Be aware of 401(k) loan limits. You won’t be able to drain the entire account to pay off your credit card debt. You can borrow the greater of $10,000 or 50% of your vested balance up to $50,000, according to the IRS. If you’ve just recently started working with a company or just recently started contributing to your 401(k), you may not have enough funds vested to cover the credit card debt bills you need to pay anyway. Don’t worry — we share some alternatives to help you pay off credit card debt below.
Reason no. 4: You may not be able to contribute to your 401(k) while you have a loan
If you have a loan out on your 401(k), you may or may not be able to contribute depending on your plan. Not contributing for up to five years would cause a triple whammy — you have less money invested because of the loan and you’re unable to contribute more cash and you may lose out on any employer matching funds. After the loan is paid off, you’ll have to play a serious game of catch up.
If you come into some money and are able to pay off the 401(k) loan entirely, some plans will only allow you to continue making payments each paycheck and won’t allow you to pay off with a lump sum. This is why you must call your 401(k) administrator to ask what they will let you do and what they won’t let you do because it can be very different across plans, said McPherson.
3 better ways to tackle your credit card debt
When you want to attack your credit card debt, there are other options besides raiding your retirement account. Here are a few:
Complete a balance transfer
A balance transfer card allows you to transfer existing, high-interest credit card balances to a new credit card that’s offering a 0% APR or low-interest special for a certain amount of time. Typically, the low-interest deal lasts for 12 to 15 months, but some cards will give you as much as 21 months interest-free.
The balance transfer strategy is to pay off the credit card debt during the low-interest period, ideally in monthly fixed installments, so you can save cash on interest and pay the debt off faster. One thing to watch out for is that some balance transfer cards have a balance transfer fee that ranges from 3% to 5%, which is added to the amount transferred.
Check out a debt consolidation loan
A debt consolidation loan, offered by a bank or credit union, can reduce multiple credit card payments into one at a more competitive interest rate. A personal loan for debt consolidation gives you a lump sum that you use to pay off your credit card debt for a fixed period of time up to several years. Then you make installment payments on the loan until it’s paid off.
If you’re stuck in the minimum credit card payment trap with mounting interest, an installment loan gives you a set payoff schedule. Make sure you get a handle on your spending and tighten up your budget before you consolidate your credit card debt with a loan. If you keep swiping, you may find yourself with a growing credit card bill again on top of the consolidation loan.
Deliberate taking out a home equity loan
If you have a home in which you have a sizeable amount of equity built up, a home equity loan or line of credit may be an option, but it has major risks. You can lose your home if you’re unable to make payments on your home equity loan since the loan is secured by your home.
Lenders generally lend up to 85% of the equity you have in the home. Home equity loan rates can be competitive, depending on your credit, because of the collateral backing. However, if you’re already having trouble managing debt, be careful with home equity products. Taking out a home equity loan puts more debt against your home, said McPherson. If you can’t pay it back, the bank may come after your house. And if the value of your home tanks with an economic slump, you may find you owe more than your house is worth.
A 401(k) early withdrawal is not the smartest way to pay off credit debt because of the taxes and penalties involved. A 401(k) loan doesn’t come with the same costs as a withdrawal, but it can still disrupt your retirement savings goals and can put you in a difficult situation if you switch jobs. Fortunately, you have other options to consider, such as a personal loan or balance transfer credit cards, to repay credit card debt that won’t rob you of a comfortable retirement.