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Q&A: Is it OK to tap my 401(k) to pay off Credit Card Debt?

When I wrote “The Recession Diaries” column at the Chicago Tribune and later for AOL.com, I loved responding to mail because questions raised by one reader often reflect the dilemmas of many.I recently received this letter from one reader, Nick from Michigan:

“I have a question regarding credit card debt and I was hoping to hear some suggestions. I am one year removed from college and have a good paying job and so does my wife. We both live within our means and don’t spend too freely. However, I have roughly $12,000 in credit card debt and haven’t been able to knock that down too much because we were self-financing our wedding and I just haven’t had the free money to put towards credit card debt. This has been weighing on me for quite some time and I just hate having that feeling. I want it gone!!!

When I was in college, I interned 3 years for a company that offered a great 401(k) program that I took advantage of. So between that and my current job, I have $20,000 saved in my 401(k). Would it be wise to take out $12,000 from that 401(k) to pay off my credit card debts? The benefits I see in doing that are as follows:

  1. Freedom from credit card debt! This would be a huge relief.
  2. It would raise my credit score. (We’ll be looking to buy a house in the not-too- distant future).
  3. It would lower my monthly expenses, so I could then pay more into my 401(k) to build that back up.

Obviously, I know there are penalties and taxes associated with early withdrawal, but I think the benefits may outweigh that. Any thoughts?”

I shared Nick’s letter with some very respected people in the finance industry whom I’ve gotten to know over the years. Here’s some of what they advised, along with my own suggestions based on my time as a personal finance writer.

Experts: Leave the 401(k) be

“Here’s what I think they need to do: Pretend it’s a three-year car loan,” says Lynn Ballou, managing partner of Ballou Plum Wealth Advisors, LLC in Lafayette, Calif.  “Get this debt onto the lowest interest rate [credit] card or credit union type loan possible. Then figure out how much to pay each month for three years to get it paid off. Cut back spending during that three year time to handle the additional hit. About $750 per month at 20 percent interest and it’s paid off in three years. Better, about $600 per month pays it off in three years at 6 percent.”

“DO NOT take money out of your 401(k) to pay down this debt,” says Susan Beacham, founder of the financial literacy website Money Savvy Generation. “Aside from the penalties you will incur if you withdraw this money, you are giving up the power of  tax-free investing over the coming 30 to 40 years. At your age, a nest egg does not sound as sexy as it will to you and your spouse when you are in your 50s. But trust me, later in life you will be grateful you did not withdraw this money – but rather, let it grow. This nest egg, grown over the years, will provide you with an enormous sense  of financial security right when you need it most. Meanwhile, get a second job to pay off that $12,000. Do you have a talent that others would benefit from? Think about it. You could be sitting on a $12,000-plus goldmine of talent!”

My advice

And my suggestion to Nick? Tackling the debt stems first and foremost from how you think about it. While it seems oppressive to have a $12,000 albatross around your neck, you’ve also got this blessing: You and your wife both hold down jobs with decent pay. Taking money from your 401(k) isn’t wise, because the big payoff comes with compound interest built over time. That $12,000 now could yield millions by retirement age if you leave it alone.

Your debt didn’t come from left field; you paid for a worthwhile milestone event, your wedding. Since you and your wife live within your means (and have no big weddings in your immediate future), sit down and calculate how much you can pour into extra debt relief every month. My guess is you can easily pay off this debt within 18 months, assuming roughly $700 month to cover principal and interest, and no new debt snowballs in between.

You will learn patience with this approach, and something more: Working at an important goal together. Money issues often create rifts between couples that never mend. Here’s your chance to turn a money challenge into a bonding experience, and a page for your marriage playbook.

Published or updated on November 12, 2012

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About Lou Carlozo

Based in Chicago, Lou Carlozo is a personal finance contributor for Reuters Money, a columnist with DealNews.com, and a former managing editor at AOL's WalletPop.com. Contact him with story ideas for Money Under 30 at feedbacker@aol.com, or follow him via LinkedIn and Twitter (@LouCarlozo63).


We invite readers to respond with questions or comments. Comments may be held for moderation and will be published according to our comment policy. Comments are the opinions of their authors; they do not represent the views or opinions of Money Under 30.

  1. GMR says:

    One additional thing to consider is if the government seizes 401Ks for deficit reduction. They may force you to invest in treasuries, or take over the plans completely. Not very likely, but it has been proposed from time to time, and we do have a large fiscal shortfall. The government could also tax the assets of 401Ks. Currently, there’s talk of limiting the amount you can put into a 401K, at least for wealthier people. But this conversation may move, crazier things have happened before (if I were to tell you in 1995 that within 15 years, TARP would be implemented by a Republican president, would you believe me?)

  2. Shawn L. says:

    My company offers the opportunity for loans against my 401(k). I agree with not withdrawing against the 401(k), but it always made sense to me to take the loan from the 401(k) and pay off the credit card debt. While your company will charge you interest on the loan, the interest paid is going directly back IN to your 401(k) rather than to a credit card company. According to T.C. above, there are tax issues with doing so, but I can’t imagine it being a large impact.

    I am of the same mind as Nick, credit card debt weighing on my mind is like a weight slowing me down. It’s difficult to focus when I’m worried about the next month’s payment.

  3. Mark says:

    I think the advice is fine in general, but since we have a specific situation the answer is easy. Quit spending your money on other crap! According to Nick, he and his wife both have good paying jobs but they haven’t had the free money to pay it down. There is no mention of children or other unusual circumstances, so there really is no reason why a couple with two solid incomes can’t pay $12,000 in less than a year.

    I am fresh out college and I am saving more than $12,000 a year making $50K with one income and a wife and kid, and I’m not even doing the whole rice and beans lifestyle either. With two incomes you can do it easily, just quit spending all your money on other stuff.

  4. T.C. says:

    I was in this same exact scenario a few years back – after moving to NYC as a recent grad with a low paying job I racked up some credit card debt and decided to take a loan from my 401K of something like $7,000.

    I was not well informed on the intricacies of the transaction and was also very poorly guided (I was ensured by the agent facilitating the withdrawal that I would not be taxed – which I was). In the end, financilly speaking it was not worth it, but I will speak to Nick’s point about the intense psychological overwhelm of carrying credit card debt. I felt completely suffocated by it – for a couple of years I carried the weight of it and had the thought in the back of my head everyday. I knew it may not pay off but the relief and freedom is what I was really after in the short-term. Perhaps I could have used some coaching on shifting my thinking or frame on it, but I didn’t. If I were to go back and do it all over again, I would have gotten another part-time job and funneled that money into paying off my debt. Although, doesn’t the timing of when the money is invested in the 401K play a part in the payoff calculations?

    Perhaps some of the financial experts on the chain can speak to the timing of investment based on market conditions. I invested my money in the 401K originally when the market was up (relatively speaking, ~2006, 2007) and took the loan during the recession, so as I paid the loan back, the money I put in was likely invested at a better time to invest. Is this thinking correct? Would love to better understand a few scenarios related to this!

  5. Travis says:

    The monthly payment calculations from Lynn Ballou are incorrect (I believe she is using the $20k 401k amount instead of $12k CC debt). 3 years at 20% would be $445 and 3 years at 6% would be $365 monthly. Much lower than what’s stated.

    As for what to do: A year after graduating college, I was in a similar situation as Nick with almost $10k in CC debt (but not a sizable $401k). First thing I did was call my bank (Chase) and negotiate a “hardship”, basically they closed my account and permanently lowered the interest rate to 6% (this did not affect my credit bc it was listed as “Closed by customer”). I also lowered my 401k contribution to 6% so that I still took full advantage of my company’s match (3%) and was able to pay off the CC debt in a little over a year (paying $700-900 a month). If his company doesn’t offer a match, I would stop contributing to the 401k until the debt is paid off, but DO NOT cash out.

  6. D – Not enough information.

    In my mind there are several bits of information needed to determine what is the best alternative: your marginal tax rate, interest rate on the credit cards, your current credit scores, and how these scores might impact your mortgage costs over time.

    Credit card balances and utilization impact your score for exactly one month. I would defer cashing out the 401K. When the time comes to take out your mortgage you will need cash for a down payment and/or repaying credit debt to improve scores. You would have the complete picture at that time and could spreadsheet the costs most accurately over time.

  7. Drew says:

    I’m like Nick and don’t like carrying debt, however, Lou is correct not to dip into the 401(k). It’s a cost/benefit issue. Nick would actually be giving up more by dipping into his 401(k) in the long run than he will pay in interest on the debt. With $12,000 and assuming a conservative 5% annual return, over the next 30 years that will grown to around $53,000. It’s better to keep that money in the 401(k). What he should do is continue to fully fund his 401(k) and try to cut back on spending each month so that he can make big payments on that debt. Maybe with a dual income, they can swing $1000 a month and have the debt paid off in less than 2 years with minimal interest.

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