Money Watch: 401(k) a bad option to pay off credit card debt

ByABC News
June 23, 2012, 5:43 AM

— -- Money Watch, a personal finance column that runs every Saturday, features a financial planner from the National Association of Personal Financial Advisorsanswering reader questions about saving, protecting and growing your money. To submit a question, e-mail USA TODAY personal finance reporter Christine Dugas at: cdugas@usatoday.com.

Q: I am 27, married and about to have my first child. I have $10,000 sitting in a 401(k) plan at a previous job. I owe $20,000 in credit card debt, with a 9.5% interest rate that is killing me. Should I take out some or all of my 401(k) saving to pay off my debt?

A: I generally would not recommend withdrawing money from your 401(k) savings plan to pay off your credit card debt.

First, there is a steep immediate cost: You will have to pay ordinary income taxes on the 401(k) withdrawal, plus a 10% penalty. This will likely reduce your balance by at least 25%, turning your $10,000 into $7,500 or less. Using this money to pay down your credit card would still leave you with a balance of $12,500 and if you have no other retirement account you will have zero retirement savings.

Second, there is a much larger long-term cost. By withdrawing the money now, you will not be able to take advantage of the long-term growth of your 401(k). For example, say your $10,000 was to grow at an average rate of 6% per year for 35 years. At the end of the 35 years your 401(k) would be worth $76,861.

So for every $1,000 you withdraw today, you could be costing your future self $7,686. This is a very expensive way to pay off credit card debt.

Here's what I suggest first: Together with your husband, make a commitment to get a handle on your family finances and develop a plan that will help you have financial security now and in the future. Part of achieving that is having a plan to pay off your credit card debt as quickly as possible.

Since using your 401(k) retirement savings to pay off your debt is not a good option, the money has to either come from spending less or earning more. Some ways to do that:

•Track where your money goes. Start by writing down every single household expense you have for at least a month. Use this to help identify specific areas where you can reduce or eliminate spending, and you can then use the savings to pay down your credit card debt.

•Try and lower your credit card rate. Even though 9.5% is a relatively low interest rate for a credit card, it may be worth contacting the credit card company to see if they can reduce your rate further. Before you call them, go to a website, such as CreditCards.com, that can provide a script to reduce credit card rate and tactics on how to increase your odds of success.

•Earn extra income. This could involve working a side job, asking for a raise at work or selling some of your belongings. Use the extra money to pay down that debt.

•Consider reducing retirement plan contributions. If you or your husband currently put money into a 401(k) plan, think about reducing your contributions temporarily in order to give you more cash to pay down debt. But if the employer offers a company match, don't reduce your contributions below that threshold.

If your situation is more dire and you simply do not have the money to make ends meet, you may want seek financial counseling and debt management help.

Brent Perry, NAPFA-registered financial adviser

Piedmont Financial Advisors, Indianapolis, Ind.

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