To dip or not to dip?

May 24, 2008 1:33 PM

Should my friend dip into her 401k to pay off credit card debt?

She has $9,000 in credit card debt. Her husband's 401k has $10,000 (not invested, in cash) and her 401k has around $65,000. She wants to deplete the $10,000 401k to pay off their credit card debt. Right now she is paying the minimum amount on her credit card each month. They live paycheck to paycheck. They also have $5,000 in an emergency savings account.

Thoughts? Is it always a bad idea to dip into a 401k?

posted by JPowers to work & money (12 comments total)

Not ALWAYS. But I can't see why the first recourse isn't to the emergency savings account; the 401k could temporarily serve as the backup in that regard, and the use of the savings wouldn't have the tax consequences and penalties that might be associated with the 401k.
posted by Clyde Mnestra at 1:38 PM on May 24

What's their present tax bracket? If they are in the 28% bracket then taking money out of the 401K is expensive since money coming out the 401K is taxed as ordinary income + 10% (but you get some of the 10% back as a tax write-off).

If they are making contributions to the 401K then it might make sense to redirect that money to the credit card instead.

It might make the most sense to borrow the money from the 401K plan, then pay it back over 20 months.

Money borrowed from the 401K is NOT taxed twice, contrary to what some people get off the internet. (The interest you pay to yourself is, however, but that isn't that significant)
posted by tachikaze at 1:48 PM on May 24

She'll have ordinary income tax and penalties (10% iirc), so taking a loan from her 401(k), where tax and penalty do not apply, rather than a straight withdrawal is a better option, if it's available.

Failing that, this is a job for Excel.
posted by Kwantsar at 1:49 PM on May 24

I think there are better choices. Has she thought about something like Prosper?

I'm getting a loan through prosper to pay off some credit cards. My rate will probably be about 8%, which is much lower than the rate I'm paying on my cards.
posted by iwhitney at 1:52 PM on May 24

Is their credit decent? If so, the first step could be to open a new credit account(s) with a 0% intro offer. This will by them 6-12 months to pay down as much as they can out of their paychecks. Even just making the minimum payment, the balance will go down b/c no interest is being added.

After that, they could use the savings account to pay it down. I can't think of any emergency where they couldn't just use the freed-up credit anyway.
posted by drjimmy11 at 1:52 PM on May 24

She'll be penalized for the 401k withdrawal, so while I think it's very nice and responsible to have the emergency savings account, I'd use that first. After all, you can always go to 401k for an emergency, without the penalty. So, savings first, then the smaller 401k. They'll still have a lot of 401k savings left.

I say this because I know what it's like to try to get out from under credit card debt living paycheck to paycheck, and it's really nice, both financially and mentally, to have it GONE. I depleted my 401k at one point to help accomplish that, and for me, I'm much happier building up my savings again now than I was having the equivalent of a year's salary in credit card debt.
posted by iguanapolitico at 1:52 PM on May 24

(Or, of course, there are other options, like living super frugally and just paying it down slowly.)
posted by iguanapolitico at 1:53 PM on May 24

Kill the emergency account first. The savings account is probably earning something small like 3% in interest each month, while the credit cards are costing 13-21% in interest each month.

Does her 401(k) [or her husband's] provider offer the ability to borrow from their accounts? If so, that's far better than a straight withdrawal, especially since the interest she'd be paying goes back to her own account.

She should also pay off the highest-interest card, not the lowest-balance card, for the same reasons; the latter may be more psychologically fun, but there can be a very, very significant difference in how long it'll take her to eliminate her debt between the two strategies: the highest-interest strategy is the quickest.

As for the 401k, there's very significant financial penalties, so getting it out of there is going to significantly cost her. Instead, I'd recommend a temporary severe cutdown everywhere she can. Reduce the cable package down to limited, cancel a landline if she's got cells, etc. Fool.com, Get Rich Slowly, and other sites/blogs along the same lines could help her.
posted by WCityMike at 2:05 PM on May 24

I'd say use the emergency savings. As others have said, in the case of an emergency you still have the $10,000 401K, but you also have the $5,000 in available credit card balance that you just paid off.

It might seem depressing that you're back in debt to the same tune, but really it's a better situation. The interest you're paying on that credit card is certainly more than what you're savings account is paying you. So between now and the emergency, you save a significant amount on interest payments alone.
posted by sbutler at 2:10 PM on May 24

I had a wad of debt that was annoying me a while back. I had been paying the maximum into my 401K but took some loads, dropped what I was paying into my 401K, etc. Ultimately I decided that the financial penalties were not as painful as all that (It's basically 10% off the top plus taxes) and went ahead and took the payout.

I'd deplete the emergency savings account first (you can always use credit cards for an emergency if it comes to that - the trick is not labeling everything an emergency). Then, if the remaining debt is still not manageable, take a payout that's just enough to cover the remaining debt.

Something they should consider is their age. If they are relatively young I'd say go ahead and do it since, based on the steady hand that's been at the tiller for the past few years, I can not imagine taxes not going up in the future. I'd also, the moment I was out of debt and had a spare thousand or so back in the emergency account, look into setting up a Roth 401K.

Also, is there any reason that $10K is just sitting there? I'd look hard at rolling any remaining money into something that would get some kind of payoff on investment, even if it was something safe but low yield, just to keep up with inflation.
posted by Kid Charlemagne at 2:29 PM on May 24

I would say that they need to stop putting money into the 401k's and funnel what would have been going there into the debt, and additional emergency funds. Combine that with iguanapolitico's above suggestion of living frugally, and they can probably knock this debt out very quickly and be in a better situation overall when it's done.
posted by joshrholloway at 2:33 PM on May 24

Just to add, if she's going to stay in the same job for the foreseeable future she can withdraw from the 401k as long as she pays it back before she leaves the job.
posted by rhizome at 12:06 AM on May 25