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Is paying off debt with my 401(k) a good idea?

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hand_over_401kQ: I have about $100,000 in my 401(k) balance and I am 50 years old. Unfortunately, my credit-card debt has gotten out of hand lately, and has built up to over $10,000.

I am thinking of taking money out of my 401(k) to pay off the credit-card debt and avoid the high interest on what I owe. I know there is a penalty for taking money out of a 401(k) early, but what is that penalty and is it worth it in this situation?

A: Credit-card debt is extremely expensive, so it is understandable that you would be anxious to eliminate it as quickly as possible. However, it may be even more costly to take money out of your 401(k) early, so you should consider other alternatives.

The triple penalty for early 401(k) withdrawals

People are often aware that there is a penalty for early 401(k) withdrawals; but what you might not realize is that, in effect, it is a triple penalty:

  1. You will pay a 10 percent tax penalty
    A 10 percent penalty applies to most distributions take from a 401(k) plan before the participant reaches age 59 1/2.

  2. You may face a higher income tax rate
    One advantage of tax-deferred retirement plans is that people often are in a lower tax bracket when they take the money out in retirement than they were during their working years. If you take the money out now, it will be subject to ordinary income taxes, which could possibly be at a higher rate than when you are retired.

  3. You will miss out on years of tax-free growth
    Money invested in retirement plans can grow tax-free, but you will miss out on some of this growth if you take the money out.

Alternatives to taking money out of a 401(k)

There is no easy solution to your problem, but here are some alternatives to consider:

  1. Tighten up your budget
    Unless you get your spending under control, this problem could get even worse. Once you reduce spending, however, you can see how much is left over to start paying down those credit-card bills.

  2. Suspend your 401(k) plan contributions
    If you've been putting money into the plan regularly, you may suspend those payments and put them toward paying down credit-card debt instead. While this is better than getting hit with a tax penalty, it could be costly if you benefit from an employer match.

  3. Borrow against your 401(k) balance
    Some plans allow for this, and there is no penalty if you repay the money on a timely basis. However, this is not ideal because you will miss out on some investment growth in the meantime.

  4. Borrow against home equity
    Only do this if you have your spending under control; but if you do, this at least should help reduce your interest expense considerably compared with credit-card debt.

It's a good thing that you have realized how detrimental paying credit-card interest is -- but taking money out of your 401(k) early is no bargain either. The good news is that, if you dedicate yourself to getting out of debt, you can turn your financial situation around more quickly.


More resources on getting out of debt:

Carrying a balance? Try our credit card payoff calculator

Calculator -- Should I switch to a lower-interest credit card?

How should I prioritize my debt?

7 ways retirees can profit from downsizing 

9 ways to get serious about money


More resources on 401(k)s:

401(k) loan--borrowing from or robbing yourself?

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