Tuesday, October 11, 2005

Should You Raid Your 401(k) to repay credit card debt


Dear Steve,

My husband and I have about $40,000 in credit card debt, and I know that in October the minimum payments will double. I'm considering borrowing from my retirement savings to pay off some of this debt. Do you think this is wise?
-- Robin


Dear Robin,

That's a lot of credit card debt you've got there. And you are right about those minimums increasing soon. Under new federal guidelines, almost everyone who is carrying a credit card balance can expect higher minimum payments before the end of the year. But I am not so sure that you should borrow from your retirement to decrease your debt.

You didn't say what type of retirement account you have, but I assume it is a 401(k), since these plans often have a provision for borrowing up to 50 percent of the vested value. Repayment is generally through payroll deduction, and interest is usually charged at a low rate, which is credited to your account. Repayment begins immediately and in most cases must be paid off in 60 equal monthly payments over five years. There is no penalty for prepayment. Sounds good so far, right?

Unfortunately, there is this guy out there whose name is Murphy. He is so popular that he has a law named after him. Murphy's law says: If something can go wrong, it will. So let's look at what can happen.

If you lose or leave your job before the loan is paid off, the balance of the loan usually must be paid in full at termination or it will be treated as a distribution. "Distributed" 401(k) money triggers a federal tax penalty, of 10 percent, for early withdrawal if you are less than age 59½, and you will have to pay federal income taxes on the distributed amount. If you are in a 25-percent tax bracket, the taxes plus penalty mean you will have to surrender 35 percent of your balance. If you live in a state with an income tax that will be charged, too, you could lose as much as 50 percent to state and federal income taxes. Check your plan for specifics before you do anything like this.

The reason this penalty exists is because Uncle Sam doesn't want you to use your retirement to pay off your debts; he wants you to save it for your retirement! So do I.

Even if you feel your job is as secure as Fort Knox and you will not have a problem with the additional withdrawal from your paycheck, I would urge you to try another method of getting your debt down before breaking open the retirement piggy bank.

Here are my suggestions:

  • Stop using the cards. Don't add more to your pile of debts; use cash.
  • Set some goals. Agree on some five-year goals for you and your family. Make one of them to retire the debt in 60 payments or less. Few people can live like monks for five years, though, so make sure your plan includes some fun and affordable goals. They will give you incentives to stick to your goals.
  • Get a plan. Develop a spending plan that encompasses your goals and current needs. Make it real by posting pictures of your goals and dreams on the refrigerator so you both can see them every day.

My bottom-line advice is to not rob tomorrow to pay for yesterday. If you don't stop, when you get to tomorrow, you will find that it has been emptied not only of money, but of hopes and dreams as well.

If you can't agree on the goal-setting and spending plan, find yourself a good, accredited credit counselor to help you find a way out of this $40,000 debt without risking your future to do it. Good luck!

The Debt Adviser, Steve Bucci, is the president of Money Management International Financial Education Foundation and the author of Credit Repair Kit for Dummies. Visit MMI for additional debt advice or click here to ask a debt question.

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