Money Girl explains how to tap your 401(k) before retirement and whether using it to pay off credit card debt is a wise move.
A Money Girl podcast fan named Amy asks:
“I’m in my late-twenties and already have about $20,000 in credit card debt. I only have $2,000 in savings, but my 401(k) has over $20,000. Should I use my retirement funds to pay off my credit cards?”
If you have money sitting in a retirement account, it can be awfully tempting to spend it. I’ll cover what you need to know about dipping into retirement savings and whether using it for credit card debt is a smart move.
What Is a 401(k) Retirement Account?
Different types of retirement accounts have different rules for taking withdrawals. Since Amy asked about her 401(k), that’s the type we’ll focus on today.
A 401(k) is a common type of retirement plan that’s offered by many employers. You elect to have your company deposit a percentage or a flat dollar amount from each paycheck into your 401(k) before taxes are taken out. That’s a nice benefit because you don’t pay tax on contributions or their investment earnings until you take distributions in retirement.
For 2012, you can contribute up to $17,000 or up to $22,500 if you’re age 50 or older. Additionally, many employers encourage workers to save by “matching” contributions and depositing additional funds into their accounts.
Related Content: Should I Include Matching in My Retirement Plan?
How to Withdraw Funds from a 401(k)
What trips up many people about workplace retirement accounts is that you can’t just withdraw money anytime you want, the way you could with a bank savings or a taxable brokerage account. You can only take distributions from a 401(k) in very limited situations—such as when you leave the job, reach the official retirement age of 59½, or become disabled.
However, some 401(k) plans allow for hardship distributions when you demonstrate that you have a financial need and no other options. Hardships are specific circumstances approved by the IRS. They include paying for college, buying a main home, avoiding foreclosure on your primary residence, or having unpaid medical or funeral expenses. So Amy would have to prove that her credit card debt was related to a permitted hardship in order to take a withdrawal.
Related Content: Can I Take a 401(k) Withdrawal to Buy a Home?
Though hardship distributions may be allowed in some 401(k) plans, I never recommend them because they’re expensive. Distributions are subject to income tax, plus an additional 10% early withdrawal penalty if you’re younger than age 59½.
Also, if you think you can take a distribution and simply reimburse the plan later on, think again. Contributions to a workplace retirement plan must come from payroll deductions—you can’t just make a random, additional deposit.
How to Take a Loan from a 401(k)
If you don’t qualify for a hardship distribution, some 401(k) plans do allow loans. When you take a 401(k) loan, you can spend it any way you like, including credit card debt.
You can borrow up to 50% of your vested account balance, up to a maximum of $50,000. Loan payments are typically withheld from your paycheck in level amounts over the life of the loan, which could be as long as 5 years.
Vesting refers to the portion of the account that you own. You’re always 100% vested in 401(k) contributions that you make. However, you may not own some or all of the contributions that your employer made, such as matching contributions or profit sharing.
For instance, an employer could fully vest their contributions after you’ve worked for a certain period of time, such as 2 or 3 years, which is known as cliff vesting. Or they could vest on a percentage basis, such as 20% each year over a 5-year period, which is known as graduated vesting. Some 401(k) plans give immediate vesting from day one. So check your plan document or ask your benefits administrator for details.
Amy said she has over $20,000 in her 401(k). Let’s say that her vested portion is $16,000. If loans are permitted, she could borrow a maximum of $8,000, or 50%, from the account. There’s no tax on money borrowed from a 401(k)—if you repay it according to the rules. However, you do have to pay interest to your account at a rate specified in the plan document.
Related Content: 10 Things You Show Know About 401(k) Plans
Should You Take a 401(k) Loan?
Taking a loan from your 401(k) is a better option than taking a hardship distribution; however, it isn’t necessarily a wise decision either. Not only does taking a loan leave you with less money invested for retirement, it also puts you in financial danger if you get laid off before the loan is fully repaid.
If you lose your job while you’re repaying a 401(k) loan, the entire balance is due within 60 to 90 days. If you can’t come up with the full amount, the outstanding balance is considered an early withdrawal, which is subject to income tax plus an additional 10% penalty, if you’re younger than age 59½.
Though you pay interest to yourself on a 401(k) loan, you still miss out on potential investment gains and tax benefits on the balance you withdraw. Even if the interest rate you pay is higher than the account’s investment growth rate, you can still lose money in the long run. Before taking a loan, always research the financial consequences by entering your information into a 401(k) loan calculator.
Here are 4 reasons why taking a hardship distribution or a loan from your 401(k) should be avoided:
You may be subject to a 6-month waiting period when you can’t make any new contributions to your plan—and you lose potential matching funds.
You lose out on years of potential account growth.
You must pay a 10% penalty, in addition to income tax, on early withdrawals.
You lose legal protection because 401(k) funds are shielded from creditors if you declare bankruptcy.
For all these reasons, never take money out of your 401(k) if you can help it. If you hit a financial rough patch, it would be unwise to drain your retirement funds when your creditors couldn’t legally touch them. So, always consult with a CPA or a bankruptcy attorney before tapping a retirement account.
Related Content: How to Save for Retirement on Less Income
How to Pay Off Credit Card Debt
To pay off her credit card debt, Amy should immediately create a realistic financial plan. For instance, if the average interest rate on her cards is 18%, a $20,000 balance could be paid off in 5 years if she pays $500 a month.
The first step for Amy is to stop making new credit card charges so she doesn’t increase her debt balance. Then she needs to create a spending plan so she knows exactly how much she earns and spends each month. My book Money Girl’s Smart Moves to Grow Rich shows you step-by-step how to do this.
The bottom line is that Amy needs to dramatically cut spending or find ways to earn more so she can live within her means and have money left over to kill her credit card debt—instead of tapping her 401(k) and jeopardizing her retirement.
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