As a general rule, it’s almost never a good idea to tap into your retirement savings early, as that’s the money you’ll need to get through what could be decades of limited income. This applies even if you have heavy credit card debt you want to pay down.
But as with any rule, there are always exceptions — and those exceptions are especially relevant now, with rising interest rates contributing to record-high credit card APRs.
If you are thinking about tapping into your 401(k), IRA or other retirement account to pay down credit card debt, you should first be aware of the risks. The biggest risk is that if you withdraw money before a certain age, you could face a 10% penalty along with a 20% federal income tax hit.
For those with 401(k)s and IRAs, that age is 59½. If you withdraw money from your account before then, you’ll almost certainly get hit with a penalty. Depending on your credit card balance, the combined penalty and tax obligation might be nearly as much as the debt itself. Suppose you need to cover a $15,000 credit card debt. In this case, you’d have to take out close to $24,000 after accounting for the penalty and tax charges, CNBC reported, citing data from Fidelity.
Even if you’re old enough to withdraw money with no penalty, you’ll still face the tax bill. You also might miss out on investment gains by lowering the amount in your retirement account. When the stock markets are rising, the more money you have in the account, the more you earn.
That’s not as big a consideration now, as markets have been on a steady decline over the past year. So, it might be a good time to pay down high-interest credit card debt rather than watch your retirement savings languish.
“Certainly, the math can make it worth it,” Allan Roth, a certified financial planner and founder of Colorado-based Wealth Logic, told CNBC.
Consider Pausing Retirement Contributions in Favor of Debt Repayment
You don’t necessarily have to withdraw money from your 401(k) or IRA to pay down credit card debt. Another option is to stop contributing to them for a while until your debt is erased. This is the better alternative because you don’t face any penalty or tax hit. Once the debt is erased, you can pick back up with your retirement savings.
“Stopping your 401(k) contributions for a while — or at least cutting back — and redirecting those funds to debt payoff might make sense,” Ted Rossman, a senior industry analyst at CreditCards.com, told CNBC.
But again, this isn’t a perfect solution because you might miss out on the employer match during the time you suspend contributions, which means turning away free money.
One other option is to take out a loan on your retirement account and use the loan to pay off credit cards. According to the IRS, certain 401(k), 403(b) and 457(b) plans may offer loans to participants, though IRAs and IRA-based plans such as SEP, SIMPLE IRA and SARSEP plans cannot offer participant loans.
To receive a plan loan, you must apply for the loan and the loan must meet certain requirements. You should receive information from the plan administrator describing the availability of (and terms for) obtaining a loan.
As the AARP noted, this kind of loan might be a good idea if you are still working and have the ability to repay the money to yourself without tax consequences. Here are a couple of good rules to follow if you are considering a 401(k) loan to pay off credit card debt:
- Set up a repayment plan that is three years or less.
- Make sure you’re confident that you’ll remain with the same company during that three-year period.
The first rule helps ensure that your money can begin earning interest again as soon as possible. The second rule is important because whenever you separate from an employer, any outstanding retirement loans typically come due.
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