Should I tap my 401(k) to pay off debt?
"Arielle Answers鈥� is an investing and retirement Q&A column for all ages and life stages. I鈥檓 here to help you save more and reach your investing goals, whether that鈥檚 retirement, a house down payment or college for your kids. These are things I鈥檓 saving for, too.
If you have a question, I鈥檇 love to answer it. (The disclaimer: I won鈥檛 tip you off to the next hot stock or the best mutual fund because I can鈥檛 predict the future.) Send a question to聽arielleanswers@nerdwallet.comand it may appear in an upcoming column.
Q: My wife and I have a substantial amount of credit card debt. Does it make sense to use 401(k) money to clear the debt?
There鈥檚 a long answer to this question and a short answer. The short is just one word, two letters: No.
That鈥檚 because the IRS doesn鈥檛 give you the聽聽鈥� pretax contributions, tax-deferred investment growth 鈥� out of the goodness of its heart. The money is supposed to be earmarked for retirement; if you pull it out before then, you鈥檒l pay income taxes and a 10% penalty.
Depending on your tax bracket, you could immediately hand over a third of what you鈥檝e withdrawn; to have enough money left over to pay off a $20,000 debt, for example, you might actually need to pull out $35,000.
And then there鈥檚 the opportunity cost of pulling that $35,000 out of the market, where 鈥� if left invested 鈥� it could grow to around $150,000 after 25 years, assuming a reasonable 6% average annual return.
In other words: Unless you need the money to save a life, the math quickly rules out an early withdrawal. But let鈥檚 talk about some alternatives.
First, a word about 401(k) loans
Not all providers allow it, but聽you may have read about this option in your plan documents. I don鈥檛 actually consider this a good alternative to pulling from your 401(k), and I want to explain聽why. With a 401(k) loan, you borrow money from your account, then pay yourself back with interest. On the surface, these seem like a gift: You can avoid an early distribution, pay off that debt in one chunk, and pay interest to yourself rather than to a credit card company. Win-win, right?
Again, no. These loans are a rosy-sounding solution, but they should be a last resort because of a litany of caveats. The biggest: If you leave your job, you鈥檒l typically be required to repay the loan within聽60 days. If you can鈥檛 聽鈥� say, because you were laid off 鈥� the amount outstanding is treated as an early withdrawal (say hello to that 10% penalty and income tax).
Credit card debt is stressful; adding money owed to the IRS would be piling on. A 401(k) loan is marginally better than an outright distribution, but it falls near the bottom of your list of options. And you do have options.
Lower your interest rates 鈥�
Before you do anything drastic, try聽聽or consolidating to聽聽or a.
A balance transfer promotional period might buy you 15 to 18 months; you want to pay off the debt before the rate shoots up. It鈥檚 a good option if you have excellent credit. Depending on your credit score and credit card balance,聽you may not be able to transfer the full amount, but knocking the interest rate down on even a portion is helpful.
A personal loan might stretch two to five years and allow you to consolidate your full balance; banks and credit unions that offer these loans are sometimes more accepting of a dinged up credit score, but they鈥檙e not the free(ish) ride of a 0% balance transfer. Make sure the聽聽is lower than you鈥檙e currently paying.
鈥� then change your priorities for a while
If an interest rate break isn鈥檛 enough, you can consider making some bigger changes. Don鈥檛 worry, I鈥檓 not going to tell you what to聽cut from your聽聽to wail on this debt. You know all that, and you鈥檝e probably already done it. But at this point, you may want to free up even more cash, not by tapping your 401(k), but by scaling back your contributions to it.
The blanket advice is to聽. This is especially true if you鈥檙e offered a 401(k) that comes with matching dollars from your employer 鈥� also known as free money. But once you鈥檙e earning that match, the choice between contributing more and paying off debt mostly comes down to the debt鈥檚 interest rate versus your annual investment return. Also consider that by redirecting pretax retirement savings toward debt, you鈥檒l lose out on that tax break.
Credit cards often charge an interest rate that well exceeds what you can reasonably earn investing, so it can make sense to lower your contribution percentage and get out of that debt 鈥� especially if you can do it in less than five years.
If you鈥檙e looking at a longer stretch 鈥� or you鈥檝e already done all of the above 鈥� it might be time to look at聽. It will open the door to some additional resources, while preserving the retirement savings you鈥檝e worked hard to build.
Arielle O鈥橲hea is a staff writer at NerdWallet, a personal finance website. Email:聽aoshea@nerdwallet.com. Twitter:聽.
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