Dear Mary: I am thinking of taking a loan from my 40l(k) retirement account to pay off my credit-card debt. I can repay the loan with payments taken directly from each of my paychecks, without any penalties. The interest rate is not too bad, and a lot less than I am paying to my credit card companies now. This seems like a great idea to me, but I’m worried I might be missing something. Sharon
Dear Sharon: I would not recommend you take a loan from your retirement account to repay your credit-card debt for these three reasons:
1. Uncertainty. If you leave your job for any reason before the loan is repaid, the entire balance becomes due and payable. That’s the law. You’ll have a couple of weeks to come up with that money. If you cannot, the balance owing will be converted to a withdrawal. You will be hit with early-withdrawal penalties and you will owe both federal and state taxes on the entire remaining balance. The penalties are stiff because you’re not supposed to have access to this money until you are at least age 59 1/2. The penalties and taxes could easily add up to half of the amount you owe. Ouch!
2. Stunted growth. You lose the benefit of growth while those funds are being loaned out to you. The reason you are contributing at all is to allow money to grow steadily over a long period of time to support you during your non-earning years ahead. Taking money out brings that process to a screeching halt.
3. Double taxation. The benefit of a traditional 40l(k) account is that you get to contribute and invest pre-tax dollars. You get to defer taxes until you take it out in retirement. If you borrow now, you must repay the loan with after-tax dollars. Are you with me? If you borrow say, $10,000 you will have to earn about $13,000 gross to end up with $10,000 after-tax dollars to repay the loan. You don’t get to repay with pre-tax dollars, so that’s the first taxation. Then, when you retire, you will pay tax on the same $10,000 dollars—taxation number two. All money in traditional retirement accounts is taxed upon withdrawal regardless if the funds were borrowed then paid back with after-tax dollars.
It is just too risky and expensive to borrow from a 401(k). If you are really strapped, you could halt contributions to your account temporarily, while leaving the balance alone to grow. That would beef up your paycheck with more money to pay down your debt.
Stop thinking of your 40l(k) account as your personal ATM machine. That money is simply out of reach for now.
My advice is to get busy repaying your credit card debt from your current income. If you stop adding new purchases to those accounts and take advantage of my Rapid Debt-Repayment Plan, you will be out of debt in record time—with your 40l(k) account intact, and steadily growing.
Dear Mary: What if I put my money in a CD (certificate of deposit) for say one year, but have an emergency and need the money before that? Can I get my hands on it? Edie
Dear Edie: Yes. It would be considered an early withdrawal and for that you would be penalized pretty heavily. Depending on how far you are from the maturity date, they will reduce the guaranteed interest you would have received. The penalty applies only to the interest, however, never to your principal or initial deposited amount.