Many Americans are paying more interest fees on their credit card balances than ever due to the all-time high national average interest rate. Therefore, they may be debating whether or not it is wise to use their retirement funds to settle their debt.
Since many people have their life savings locked up in job retirement plans due to automatic enrollment and company matching contributions, this makes perfect sense.
There are primarily three methods by which one can use 401(k) funds for credit card debt repayment. They can pull money out of the account, take out a loan against it, or pause their payments into the account. What you need to know about those three choices is provided below.
Withdrawing money from a 401(k) is bad for most people. There is a 10% penalty and taxes on 401(k) withdrawals made before age 59.5. That implies you’d have to withdraw close to $24,000 (after fees) if you wanted $15,000 from your 401(k) account.
Naturally, withdrawing funds means missing out on potential profits in the market. Over the past century, stock investments have generated an annualized return of over 10%.
All of that should combine to greatly surpass the average credit card rate, as Ted Rossman, a senior industry analyst at CreditCards.com, put it.
However, there might be an exception.
Allan Roth, CFP, creator of Wealth Logic in Colorado Springs, says a 401(k) withdrawal for credit card debt might make sense for people over 59.5 with low tax rates because they would escape the 10% penalty and not be liable to a hefty fee. With proper calculations, “it can be worth it,” Roth added.
However, Rossman argued that withdrawal was not the best choice for most people because better alternatives were available.
When you put off making contributions, you lose out on the company’s matching contribution. He said it might make sense to put off (or at least reduce) your 401(k) contributions while you focus on paying down your debt. However, a caveat applies to that recommendation.
Experts advise putting away at least the amount up to which your business will match your contributions, whether it’s 3% or 5% of your salary.
As Rossman put it, this “free money” may quadruple your return.
According to the experts, an alternative to withdrawing from a 401(k) is taking out a loan.
There are restrictions associated with taking out a loan from your 401(k).
A 401(k) loan’s interest rate is normally less than 5%, significantly lower than the annual percentage rate (APR) charged on most credit cards. Loan interest is repaid directly into your savings account rather than to a financial institution.
The head of editorial content at Fidelity Institutional, Jessica Macdonald, suggests using a 401(k) loan for high-interest debt to save money on interest payments. Macdonald further noted that 401(k) loans do not affect your credit score or need a credit check.
However, there are more details to think about. First, you must have the financial wherewithal to pay back the loan in full within five years. If you lose your work and cannot repay the loan, you may face serious repercussions. As a result, you would default on your loan and be subject to paying taxes and the 10% withdrawal penalty on the remaining balance. Additionally, you will lose out on potential gains from the market.
According to financial experts, before taking money out of their 401(k)s to pay off credit card debt, borrowers should analyze the behavioral factors that contributed to their financial difficulties.
Paying off credit card debt with a loan only to use the funds to make new purchases and rack up debt is a losing strategy, according to Roth.