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1. Most people should avoid 401(k) withdrawals
Withdrawals from 401(k) accounts before age 59½ are subject to a 10% penalty and taxes. That means if you needed $15,000, you’d need to withdraw nearly $24,000, according to Fidelity, after factoring in those costs.
Of course, any money you withdraw from the account also misses out on market profits. Stocks have delivered an average annual return of more than 10% over the past 100 years or so.
All of that “should add up to much higher than the average credit card rate,” he said Ted Rossmana senior industry analyst at CreditCards.com.
However, there may be exceptions.
It may make sense to put your 401(k) contributions on hold for a while — or at least cut them back — and redirect those funds toward debt service.
Ted Rossman
industry analyst at CreditCards.com
For people over 59½ and in a low tax bracket, a 401(k) withdrawal to pay off credit card debt can make sense because they avoid the 10% penalty and aren’t subject to a huge levy, explains Allan Roth, a board certified financial planner and founder of Wealth Logic in Colorado Springs, Colorado.
“Certainly, the math can make it worth it,” Roth said.
For most others, however, there are more attractive options than incorporation, Rossman said.
2. If you suspend contributions, you will miss out on your company match
“It may make sense to put your 401(k) contributions on hold for a while — or at least reduce them — and redirect those funds to debt service,” he said.
Still, that advice comes with an asterisk.
If your employer offers a company match, experts recommend that you at least try to save up to whatever point, whether it’s 3% or 5% of your paycheck.
“That’s free money that often doubles your returns there,” Rossman said.
A loan from your 401(k) plan is also usually preferable to a withdrawal, experts say.
3. 401(k) loans also come with caveats
Interest on 401(k) loans is typically less than 5%, much less than the annual fee on most credit cards. The interest paid on the loan also flows back into your savings rather than into a bank.
“Using a 401(k) loan to pay off high-interest debt, such as credit cards, can lower the amount you pay to lenders,” said Jessica Macdonald, chief of editorial content at Fidelity Institutional.
Other benefits of a 401(k) loan, Macdonald said, are that they don’t require a credit check and they don’t appear as debt on your credit report.
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But there are also other factors to consider.
First, you must be able to repay the loan within five years. You may also face consequences if you quit your job and fail to repay the loan. In such cases, your loan will be deemed to be in default and you will have to deal with taxes and that 10% penalty on anything you still owe. And again, your money is missing out on market returns.
Anyone considering turning to their 401(k) to address credit card balances would also be wise to think about the behavioral reasons why they got into debt in the first place, some experts say.
“If someone takes out money to pay off their credit card debt and then buys more to rebuild the debt, it failed,” Roth said.