Should You Use A 401k Withdrawal To Pay Off Credit Card Debt?
I've been asked this question a lot lately, whether it's a good idea to use a 401k withdrawal to pay off credit card debt. Unfortunately, it's not a simple yes or no kind of question. There are quite a few issues that you need to consider.
Don't Lock In Your Losses
First, with the way the market has been over the past several weeks, if your 401k is heavily invested in stocks, chances are pretty good that it has lost value. As long as you leave the money in the 401k, that loss is only on paper however.
As soon as you withdraw money from the 401k, any losses that you've accumulated become "locked in" because that money is no longer able to increase in value.
If you have more than 5 years until retirement, it's almost guaranteed that you will make back any losses that you've experienced as the market rebounds.
You'll Have To Pay Taxes & Fees
When you withdraw money from your 401k, you have to pay income tax on that withdrawal since it's effectively "income". You may also have to pay withdrawal fees, depending on how your 401k is set up.
That means that you'll actually have to withdraw considerably more than what you need to actually pay off your debt, possibly up to twice as much if you're in a high tax bracket.
You'll Lose Future Earning Potential
When you withdraw money from your 401k, you're going to lose any future earning potential of that money. And you probably won't be able to "replace" it down the road. If you're a long way from retirement, this can be a significant amount lost.
What Can You Earn In Your 401k?
After giving you several reasons you might not want to consider a 401k withdrawal, let's look at a couple of reasons it might be a good choice.
First, consider what you're earning on your money in the 401k. If you're paying off high-interest credit card debt, you're essentially earning a guaranteed rate on that money, at whatever interest rate you pay on the credit card.
If you're paying 18% on your outstanding credit card debt, paying that off is essentially earning you 18% on your money. If you aren't earning close to those kind of returns in your 401k, it might be worthwhile to use some of it to repay your debt.
But withdrawal is not necessarily your only option. You could consider a 401k loan, in which you "loan" yourself the money from your 401k and pay yourself the interest back into the fund. This can let you make use of the money while avoiding the income tax and withdrawal fees that come with pulling it out of the 401k completely.
Plus, you're paying interest to yourself, so in the long run it doesn't cost you anything for the loan. You need to be careful, however, that you don't leave yourself exposed. If you were suddenly unable to make the payments for some reason (losing your job, financial emergency, etc.) you could be faced with having to pay the taxes and withdrawal fees that you were trying to avoid in the first place.
Before going this route, you should discuss it with your accountant or tax advisor, since there are some requirements and rules that you need to be sure you follow.
The bottom line is there's more to consider than just the fact that you've got this lump of money sitting in your 401k that could be used to pay off credit card debt. Make sure you think about all the consequences that go along with a 401k withdrawal before you decide to use it for debt repayment.