Many people might be eager to find solutions to lower their amounts because credit card debt is on the rise, American budgets are being squeezed by inflation, and interest rates are rising.
They could check their retirement savings, most specifically their 401(k) plan, as one possible option.
It is common for people to save the majority of their money in these plans because their employers automatically enroll them. Sometimes as an additional incentive, their employer will match their contributions.
To pay a credit card debt, there are typically three ways for consumers to access their job retirement assets. You can withdraw money from your 401(k), borrow money from the account, or temporarily stop making contributions while transferring the excess cash to your credit card.
Financial gurus have cautions in each of these situations.
“As much as I dislike credit card debt, it’s hard for me to make a case that you should take an early withdrawal from your 401(k),” explains Ted Rossman, senior industry analyst at CreditCards.com.
You’ll pay a price if you do that, he explained.
Why most people should avoid taking withdrawals from their 401(k)s
Before the age of 59½, withdrawals from 401(k) accounts are subject to taxes and a 10 percent penalty. After deducting those fees, Fidelity estimates that if you required $15,000, you would have to withdraw close to $24,000.
Undoubtedly, the money you withdraw from the account will lose out on any market gains. Over the past 100 years or so, stocks have generated returns that are on par with or exceeding 10% annually.
All of this, Rossman added, “should combine to far outweigh the average credit card rate.”
However, there are exceptions.
A 401(k) withdrawal to pay off credit card debt may make sense for persons over 59½ and in a low tax bracket because they would escape the 10 percent penalty and not be subject to a significant charge, according to Allan Roth, a certified financial adviser and the founder of Wealth Logic in Colorado Springs, Colorado.
“Certainly, the math can make it worth it,” Roth said.
There are, however, generally more desirable alternatives available than a withdrawal, according to Rossman.
“Stopping your 401(k) contributions for a while — or at least cutting back — and redirecting those funds to debt payoff might make sense.”Ted Rossman, INDUSTRY ANALYST AT CREDITCARDS.COM
But there is a caveat to that advice.
Experts advise you to try to save at least up to whatever percentage, whether it 3 percent or 5 percent of your paychecks, your job offers a company match.
“That’s free money that often doubles your return right there,” Rossman said.
According to experts, a loan from your 401(k) is typically better to a withdrawal.
The annual fee on the majority of credit cards is much higher than the interest rate on 401(k) loans, which is often less than 5%. Additionally, rather of going to a bank, the interest on the loan is reinvested in your savings.
“Using a 401(k) loan to pay off high-interest debt, like credit cards, could reduce the amount you pay in interest to lenders,” said Jessica Macdonald, Fidelity Investments’ vice president of thought leadership.
A 401(k) loan also has the advantages of not requiring a credit check and not appearing as debt on your credit report, according to Macdonald.
There are caveats associated with 401(k) loans, too
But there are also other things to think about in this situation.
You must be able to repay the loan within five years, to start with. If you quit your work and don’t pay back the loan, you can also suffer the penalties. In such circumstances, your loan would be considered in default, and you would be subject to taxes and the 10% withdrawal penalty on any remaining balance. Again, you’ll lose out on market returns with your money.
Some experts advise anyone considering using their 401(k) to pay off credit card debt to also evaluate the behavioral factors that contributed to their initial debt.
“If one takes out money to pay off their credit card debt and then buys more to build the debt back up again, it backfired,” Roth said.