Each month the credit card statement is sent out like clockwork. Florida residents can predict fairly accurately when that bill will show up in their mailbox. For those with credit card debt, it is a day that they dread. Just opening the statement, looking at a principal balance and the high interest rate applied to it gives people that tight feeling in their chest. In some cases, that dread can prompt people to jump at the first solution that comes to mind.
Fixing credit card debt is a good plan, but debtors should understand the options available and the consequences of each before making a decision. Take for example withdrawing or borrowing from a 401(k). It seems like a good option to eliminate debt with compounding interest from a fund that won’t be needed for several years, but not everyone looks at the longterm costs associated with this option.
When a person withdraws funds from a 401(k) prior to retirement it means that it will be considered income subject to state and federal tax laws. So say that a person wants to pay off a $10,000 debt and is taxed at the 25 percent bracket. To pay off the debt, they would actually need about $13,333 from the fund.
But wait, there is more. There is also an early withdrawal penalty of 10 percent that is also applied to the funds. There are some exceptions such as foreclosure on a principal residence or certain medical expenses that might allow this penalty to be waived. For the individual example in the paragraph above, this increases the withdrawal amount to $15,000 just to cover the $10,000 debt.
This only touches the immediate consequences for withdrawing from a 401(k). In our next post, we’ll share the possible future consequences of this otion and talk about borrowing from a 401(k) and what restrictions or benefits that may provide.
Source: Fox Business, “Withdrawing vs. Borrowing From 401(k) to Pay Credit Card Debt,” Gary Foreman, April 29, 2013