Paying interest on a credit card loan can be frustrating and expensive. In some cases, the desire to become debt free is so great that you might be willing to do just about anything to get rid of the credit card debt hanging over you head – even take money out of your retirement account to pay off the debt.
Why It Looks Attractive
In a time of stock market volatility, you might have seen your retirement investment returns diminish – and even go negative – it might be tempting to put that money to better use by paying off debt and getting rid of the interest payments. On top of that, there is fact that when you borrow from your retirement plan, you are borrowing from yourself. So, you pay off your credit card debt, but you still need to repay your 401(k) loan. You make payments plus interest back into your account, so you are paying yourself the interest, rather than giving it to the credit card companies.
This seems like a great idea, especially since, if it is a loan from your retirement account, you won’t be charged the 10% penalty (this is on top of your tax rate) for withdrawing before reaching the age of 59-1/2, and you won’t have to report the money as income.
Why You Shouldn’t Do It
Of course, there are downsides to using retirement account money to pay off your credit card debt. First of all, if you withdraw the money outright, without using a loan, you will have to pay a penalty of 10% of the amount, if you aren’t 59-1/2. Plus, the withdrawal amount will be added to your income, and you will have to pay income tax on it.
Even if you go the loan route instead, there are definite downsides to using retirement money to pay off credit card debt. You will have to pay a loan fee and you will have missed opportunities. Without that money sitting in your retirement account, working for you, you won’t have as much later. Yes, you are putting the money back as you repay your loan, but for a time, the capital was missing from your account, and you missed out on compound interest. That will result in a smaller nest egg over time.
You also can’t discount the problems that can come with a retirement account loan if you are laid off. If you lose your job while you have a loan outstanding, most plans require that you repay the remainder of the balance within 60 days. If you default on your 401(k) loan, you won’t see a ding on your credit report, but your loan will be reported as a distribution, and you will then be subject to penalties and taxes.
In many cases, taking money out of your retirement account has the potential to cost a great deal. Consider the viability of putting together a debt reduction plan using a loan calculator before you withdraw money from your retirement account. If you do decide to take the money from your account, make sure you repay it as quickly as you can, and try to avoid penalties and taxes.