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Those stuck with a credit card balance may wonder if they should use their 401 (k) plan savings to clear their debt.
Credit cards, after all, come with high interest rates – the average fees are over 16% per year. Being tolled at this rate, it would take more than 17 years for a person with an average household balance of $ 6,300 to be released from debt if they were only making minimum payments.
At the same time, many Americans have most, if not all, of their savings in their 401 (k) plans since so many companies automatically list their workers in the accounts.
As a result, it can be tempting to use those decades-long savings to get out of debt now.
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There are three ways people can do this: by withdrawing from their 401 (k), borrowing from the account or stopping their contributions for a period and redirecting that extra money to their plastic.
Either way, the experts have warnings.
“As much as I don’t like credit card debt, it’s hard for me to argue that you should withdraw from your 401 (k) early,” said Ted Rossman, industry analyst at CreditCards.com.
This is because it, says Rossman, will cost you dearly.
Withdrawals from 401 (k) accounts before age 59.5 are subject to a 10% penalty and taxes. This means that if you needed $ 15,000, you would need to withdraw almost $ 24,000, after factoring in those charges, according to Fidelity.
Of course, the money you withdraw from the account will also miss out on market gains. Consider the S&P 500 up almost 20% for the year.
All of this, Rossman said, “should combine to far exceed the average credit card rate.”
There may be exceptions. Allan Roth, founder of Wealth Logic in Colorado Springs, Colorado, said that for people over 59 and a half and in a low tax bracket, a 401 (k) withdrawal to pay off credit card debt can make sense because these people avoid the 10% penalty. and not subject to a huge levy.
“Sure, the math can be worth it,” Roth said.
For most of the rest, however, there are more attractive options than a withdrawal, Rossman said.
“Stopping your 401 (k) contributions for a while – or at least reducing – and reallocating those funds to paying down debt might make sense,” he said.
However, this advice is marked with an asterisk. If your employer offers a match with a company, experts recommend that you try to save at least up to some point, whether it’s 3% or 5% of your salary.
“It’s free money that often doubles your return there,” Rossman said.
A loan from your 401 (k) is also generally better than a withdrawal, experts say.
The interest rate on 401 (k) loans is typically less than 5%, well below the annual fees of most credit cards. Interest paid on the former is also returned to your savings rather than to a bank.
“Using a 401 (k) loan to pay off high interest debt, like credit cards, could reduce the amount you pay in interest to lenders,” said Jessica Macdonald, vice president of thought leadership at Fidelity Investments.
Other benefits of a 401 (k) loan, Macdonald said, are that it doesn’t require a credit check and it doesn’t show up as debt on your credit report.
But there are also things to consider here.
On the one hand, you will need to be able to repay the loan within five years. You could also face consequences if you quit your job and fail to repay the loan. In such cases, your loan would be deemed to be in default, and you would be hit with taxes and that 10% withdrawal penalty on anything you still owe. And, again, your money will not benefit from market returns.
Anyone considering turning to their 401 (k) to settle credit card balances would also be wise to think about the behavioral reasons they got into debt in the first place, which should be explored and addressed.
“If someone takes money out to pay off their credit card debt, and then buys more to pay off their debt, it backfires,” Roth said.