At a Glance
At best, credit card debt is something you pay off over time while still being able to cover essential expenses and enjoy life. At worst, it can feel downright asphyxiating. Regardless of where you fall on that spectrum, you might have considered using a 401(k) loan to pay off credit card debt. And if you’re wondering whether to move ahead, and what it would entail, below are some insights from financial experts to help you decide how to proceed.
How to know if it’s worth using your 401(k) for credit card debt
Just like with every decision, especially of the financial kind, there are tradeoffs to using your retirement savings to decrease or pay off your credit card balance. But it really boils down to a simple equation in this case, according to Ann Martin, Director of Operations of CreditDonkey.
“You should consider the amount of credit card debt you have, the interest you’re paying on it, the amount you would lose from your 401(k) including taxes and fees, and the interest you would earn on that. If the former outweighs the latter, especially over a period of years, it can make sense to withdraw from your 401(k) to pay off these debts,” she says.
“Credit card debt is incredibly high-interest, and in many cases the minimum payment will not do much to actually reduce your balance. This makes it a huge priority to pay off by any means necessary, but it’s important to remember that you’re giving up the power of compound interest on your 401(k) balance and paying hefty early withdrawal fees as well,” adds Carter Seuthe, CEO or Credit Summit.
The dos and don’ts of borrowing against your 401(k) to pay off credit cards
You should also make time work in your favor – or be aware of the ways in which it could work against you when withdrawing from your 401(k) to get rid of debts.
“Never withdraw more than you need to cover your debts. Any amount that you leave in your 401(k) will save you a large amount in penalties and earn interest over time,” says Martin. “And be sure to consider years until retirement and years until full repayment of your credit card debts in your calculations. Time works on both sides of this equation.”
Finally, it’s important to consider other alternatives such as debt consolidation loans, and make sure this is truly the best one for you even if the equation makes sense from an interest rate and fee standpoint. “Refinancing credit card debt can be a good way to get it under control without tapping into your retirement funds,” adds Martin.
Commonly Asked Questions
So taking a loan from your 401(k) to pay credit card debt is often a last resort situation, but one that could make financial sense depending on your circumstances and whether you only withdraw as much as necessary. Here are some answers to a few commonly asked questions about the process.
Does credit card debt qualify for 401(k) hardship withdrawal?
Not quite, unless you used your credit card to acquire something critical, explains Martin: “Generally speaking, credit card debt will only qualify for a hardship withdrawal if the balance was accrued purchasing something necessary–covering medical bills, major repairs to a home, etc.”
What reasons can you withdraw from 401(k) without penalty?
So, are there cases in which you can access cash through your 401(k) without incurring any penalty fees?
“You generally need to be experiencing a serious financial hardship in order to qualify to withdraw early from your 401(k) without penalty. The guidelines are broad to allow for different contingencies, but generally you need to be dealing with major medical expenses or be at risk of losing your house,” according to Seuthe.
Should you pay off credit card debt before investing in 401(k)?
Paying off credit card debt before investing in a 401(k) is probably the wisest avenue since interests on credit cards can be so high, and since once the money is in your retirement fund account you’ll have to deal with losses if you want to access it before retiring, shares Martin:
“This is a much better proposition than withdrawing from your 401k to pay credit card debt, since you don’t have to deal with early withdrawal penalties.”