Should you withdraw from your 401(k) to pay off credit card debt?

Withdraw from 401k to pay off credit card debt?

By Eric Rosenberg, MBA

If you’re in credit card debt, you may be tempted to withdraw from your 401(k) plan to pay off your debt.

While this may be a good idea in limited cases, for most people it’s best to avoid tapping into your 401(k) before the government-mandated age where you can withdraw without penalties.

Keep reading to learn more about how your 401(k) works and if it makes sense to withdraw from your 401(k) to pay off credit card debt.

What is a 401(k) plan?

For many Americans with a part-time or full-time job, an employer-sponsored 401(k) plan is one of the best ways to save for retirement.

This type of retirement plan offers tax benefits that can help you save money over time while saving and investing for retirement. Even better, many employers match employee contributions, which can supercharge your retirement account savings rate.

How do they do this?

401(k) plans allow you to save and invest with pre-tax dollars. That means you don’t pay any income taxes on those funds the year of your contribution.

Instead, you pay taxes on withdrawals in the future when you’re in retirement. Most people have a lower income and lower tax rate in retirement, so this can save you money while giving you an incentive to save more for retirement.

To withdraw from a 401(k) without the 10% withdrawal penalty, you have to wait until you’re at least 59 ½ years old. That’s a big part of why you shouldn’t withdraw 401(k) funds to pay off your credit cards.

401(k) hardship withdrawal

In rare cases, you may be able to withdraw from your retirement savings without the penalty using a hardship distribution.

According to the IRS, a hardship distribution can only be made if there is an immediate and heavy financial need, and is limited to the amount required to meet the need.

Some allowable expenses include:

  • Medical costs
  • Tuition and related educational costs for the next 12 months
  • Payments necessary to prevent eviction from your home
  • Funeral expenses
  • Certain repair costs

These allowances only apply for the employee, employee’s spouse, dependents (including kids) or a beneficiary though.

However, taking out a hardship withdrawal still generally isn’t a good deal for your long-term finances. The withdraw is taxable and you won’t have that money for retirement when you may need it even more.

If you have an IRA or Roth IRA, you might want to use that as an alternative to your 401(k) to pay off your credit card debt. But that’s a bad idea for the exact same reasons.

Taxes and penalties can make early withdrawals very costly.

Don't miss out on compound interest

Another compelling reason not to withdraw from your 401(k) to pay off your credit card balance, if you can avoid it?

Compound interest.

What this means, really, is you can earn interest on top of your interest in retirement accounts. If you withdraw that money early, you limit the speed at which your retirement savings can grow too.

Compound interest is one reason why many investment gurus recommend you start saving for retirement as early as you can.

What about 401(k) loans?

Some 401(k) plans give you the ability to borrow funds from your 401(k) account. As long as you pay the funds back as required, you could avoid the taxes (for now) and the interest penalty from the IRS.

However, this isn’t a great idea for paying off credit card debt either.

If you don’t repay your loan, you will pay at least 25% of your withdrawal in taxes and penalties, though it could be more depending on your annual income and tax bracket.

If you don’t pay the funds back, you are also out those dollars when you reach retirement.

Many financial experts suggest saving at least 10% to 15% of your income each year to maintain the same lifestyle in retirement. If you withdraw early, you’re potentially setting your future self back for retirement.

Alternatives to using your retirement plan to pay off credit card debt

If you’ve made the wise decision to leave your retirement money alone for retirement, you may wonder what other options you have to pay off credit card debt.

Here are 4 popular debt payoff methods that don’t involve your retirement money.

1 - Debt snowball or debt avalanche

The popular debt snowball and debt avalanche payoff techniques are a method where you prioritize your debts by size or interest rate while paying off your balances the old fashioned way.

2 - Take advantage of a 0% balance transfer

If you have good or better credit, you may be able to open a new credit card that comes with a 0% APR introductory period.

Consolidating your higher-interest credit cards gives you an opportunity to pay off your balances without additional interest charges. Just make sure to pay off your balances before the 0% period ends or you’ll be back where you started.

3 - Refinance with a personal loan

Also credit-dependent, a personal loan could give you a way to combine your balances into one loan with a fixed monthly payment. This gives you a set payoff day for your debt and can help you build credit if you always pay on time.

4 - Earn more with a side hustle

While most people look at their budget as a way to save more for debt payments, you can also focus on your income.

A part-time gig could bring in extra cash to pay off your debt sooner. If you have old unused items around your home, you could also sell what you don’t need anymore to chip away at your debt balance.

Learn more: When Should You Get Credit Counseling? The Complete Guide

Building your credit while paying off debt

Paying off credit card debt can take months or years for some people, but there are some added benefits to paying off your credit cards.

Keep these credit score benefits in mind as added motion while you’re paying off your credit card debt.

The first benefit to your credit will come from having lower balances. The percent of your credit limits used is a huge factor in your credit score. Paying off your credit cards is one of the fastest ways to improve your credit score if you can afford it.

Paying over time, you get credit for an on-time payment every month. Assuming you always make at least the minimum payment by the due date, every payment gives you credit toward a better credit score.

Put yourself on track for debt freedom

Whatever situation led to your credit card debt, it doesn’t have to last forever. With a focus on your budget, income, retirement, and long-term financial needs, you can put together a debt payoff plan that works for you.

For most people, withdrawing from a 401(k) plan or other retirement fund to pay off debt isn’t the right choice. The cost of taxes, penalties, and lower retirement balance should have you looking at other ways to pay off your credit card debt.

About the author

Eric Rosenberg is a former bank manager and corporate finance worker with a Bachelor’s degree and MBA in finance. His work is featured at Business Insider, Credit Karma, The Balance, Investopedia, and many other websites and publications.

Written on July 28, 2020

Self is a venture-backed startup that helps people build credit and savings.
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Disclaimer: Self is not providing financial advice. The content presented does not reflect the view of the Issuing Banks and is presented for general education and informational purposes only. Please consult with a qualified professional for financial advice.

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