Many Americans are struggling with seemingly massive credit card debt balances. These balances become extremely costly, as credit cards carry an average interest rate charge of 16% annually. Since many of these same people are operating on a tight budget, people are searching for alternative ways to pay off their credit card debt. One such way is using retirement savings from a 401(k). However, experts warn that this is a costly practice that may in fact be even more expensive in the long run. Continue reading to learn more about the dangers of paying off credit card debt with your 401(k).
THREE WAYS TO USE YOUR 401(K)
Let us begin by laying out the basic strategies of paying off credit card debt with your 401(k). Later, we will go into why experts warn about each of these strategies. There are three primary ways to go about this:
- Early withdrawal – withdrawing the funds from your 401(k) before you hit the qualifying retirement age to pay off debt
- 401(k) loan – you take out a “loan” from your retirement account to pay off debt, for which you need to return the principal amount plus interest
- Halting contributions – you leave what you have already saved and redirect contributions to pay off debt
Let us take a closer look at what experts believe to be the drawbacks of each of these strategies.
Withdrawing funds early from your retirement account comes at a hefty price. This is because the government generally wants to deter you from doing so. With this strategy, you will not only have to pay the taxes on your withdrawal, but you will also have to pay a 10% early withdrawal charge. Depending on your tax bracket, this could mean you lose upwards of 40% of your funds to tax and fee charges alone, which hardly compares to the 16% average interest rate being charge on your credit card debt. Of course, you are also losing out on big potential market returns that these withdrawn funds would have earned.
Taking out a 401(k) loan is a comparatively better approach compared to early withdrawal, but it too comes at a cost. With this strategy, you owe around 5% interest on the loan you’ve taken out, but this interest ultimately gets put back into your retirement account rather than going to a bank. This loan will also not be listed on your credit report, nor will you need to a credit check. However, you must repay the loan within five years, and there are hefty charges if you default on the loan. Once again, you will also be losing out on big potential market returns.
The final strategy is to leave the money you have in your retirement account already and to halt contributions moving forward. This is a good option considering that the existing money in your account will continue to generate returns. However, the biggest case against this would be if your employer offers matching for your contributions. Their contributions are essentially free money, so if you can, try to contribute up to the maximum that your employer will match.
Overall, there are drawbacks to all of these strategies, but you may not have many options. If you can, try to make behavioral changes to help limit your credit card debt in the first place and avoid the issue of having to withdraw from your 401(k) altogether!