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The high cost of tapping into retirement savings early

Q: 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. This applies to most distributions from a 401(k) plan reached 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 careers. If you take the money out now, it will be subject to ordinary income taxes, and possibly 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 you might consider:

  1. Tighten up your budget. You will have to do this anyway because unless you get your spending under control, you will just keep having this problem. Once you reduce spending, 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 towards 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 reduce your interest expense considerably compared with credit card debt.

You have clearly realized that paying credit card interest is a lousy deal, but taking money out of your 401(k) early is no bargain either.

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