Opening your credit card statements each month and watching your debt increase can trigger a sinking feeling in the pit of your stomach. As of 2012, the average credit card debt per household is more than $6,500. It’s easy to blame high credit card debt on materialism and keeping up with the Joneses’, but these aren’t the only causes. High costs of living and decreases in income force many households to bridge the financial gap with credit cards.
Depleting your liquid savings account and putting all extra money toward debt are two ways to alleviate high balances. But when neither is an option, you may consider using your 401(k) to pay off your debt.
Tapping into your retirement account and taking out a 401(k) loan can definitely provide a quick solution to high credit card bills. Plus, withdrawing cash from your 401(k) is a relatively simple process. You speak with your plan administrator, complete the necessary paperwork and receive a check for the cash within a few days. If you owe $12,000 in credit card debt and have $40,000 sitting in your 401(k), it only makes sense to use this money, right?
Despite the peace of mind that comes from paying off credit card balances in full, tapping into your 401(k) might not be the best move. Sure, you can wipe out your debt fast, which alleviates interest fees and helps boost your credit score. But there are consequences to withdrawing money from a 401(k) before the age of 59 1/2 — costly consequences.
Taking money from your 401(k) to pay credit card debt will involve a 401(k) loan. You repay this loan through automatic after-tax payroll deductions, and you have five years to pay back the balance. If you leave the company before repaying the loan, the balance is due within 60 days. Not a problem if you have the money, but if you cannot cough up the cash, you pay a 10% early withdrawal penalty, plus income tax on the outstanding balance.
For example, if your outstanding balance is $10,000, anticipate an $1,000 early withdrawal penalty. Because the Internal Revenue Service (IRS) views this early withdrawal as income, this balance is also subject to income tax. Depending on your tax bracket, you will pay between 15% and 35% in income taxes. If you’re in a 25% tax bracket and unable to pay $10,000 from your 401(k) loan, that’s $2,500 in taxes. This is in addition to the $1,000 penalty.
Tapping a 401(k) provides quick debt relief, but it’s a dangerous move. Not only is there the risk of getting hit with a hefty penalty and taxes, taking money from a 401(k) can reduce your retirement savings.
Take cash from your retirement account as a last resort for debt elimination. Consider other options for paying credit card debt, such as applying for part-time work, selling personal belongings and reducing expenditures to generate extra cash. If your credit card debt is out of control and you can’t keep up with your payment, talk to your creditor and negotiate a debt settlement. This is when you settle your balances for less than you owe.