Do I have to withdraw from my 401 (k) to pay off credit card debt?

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The $ 2 trillion stimulus package, also known as Coronavirus Aid, Relief and Economic Security Act (CARES Act), aims to delay federal student loan payments and send a relief check for $ 1,200 to many Americans. It will also allow people to withdraw up to $ 100,000 from their retirement savings without penalty fees.

It might sound tempting if the coronavirus pandemic puts you in financial stalemate, but Thomas Nitzsche, financial educator at Money Management International, Inc (a 501 (c) (3) nonprofit member of the National Foundation for Credit Counseling), does not recommend dipping into your retirement savings to pay off credit card debt – without penalty or not.

Why Nitzsche used his 401 (k) to pay off his credit card debt

Nitzsche speaks from experience. He is now 40 years old and self-proclaimed a “credit addict” with a credit score of over 800, but in 2008, when he was in his 20s and was laid off, he had to pay a mortgage. on a new home, just over $ 20,000 in student loans and over $ 10,000 in credit card debt.

He made some lifestyle changes, such as having three other people live in his St. Louis, MO home at the time to split mortgage payments and utility payments. But one of the most important decisions he made was to fully dip into his retirement savings – which he estimated to be around $ 20,000 at the time – to pay off his credit cards. Nitzsche tells To select that it was a decision he probably wouldn’t make again.

“This decision was made largely out of panic and out of priority,” Nitzsche said. “I knew I wanted to do everything I could to stay in shape to keep my house because I had just bought it a year ago and was obviously very proud to be a homeowner.”

But now that more than ten years have passed, Nitzsche is still feeling the effects of his decision, and he’s not sure he would encourage someone in a similar scenario to do what he did.

Why he doesn’t recommend that you make an early withdrawal

Looking back, Nitzsche says liquidating his 401 (k) to pay off credit card debt is something he wouldn’t do anymore.

“It’s so damaging to your long-term financial health and to your retirement,” he says.

Many experts agree that tapping into your retirement savings early can have long-term effects. This can put you at risk later in life when you are older, not working, and would otherwise need to rely on those funds.

There are also short-term effects to making a early withdrawal of your 401 (k) thus: it is not free. This has costly consequences, including penalty fees and taxes. For borrowers age 59 and a half and under, there is usually an early withdrawal penalty of 10%, plus taxes, which can range from 20% to 25% depending on your income and tax bracket.

If you are strapped for cash during these uncertain times, tap into your retirement savings are an option of last resort. “It really shouldn’t have been touched and it’s not something we would usually advise someone to do,” Nitzsche said.

What about penalty fee withdrawals from your 401 (k)?

Even with the recent stimulus package, which relieves Americans of penalty fees when they opt out of their 401 (k), there are still taxes that will be applied.

“Many of us have already seen a significant drop in our 401 (k), and withdrawing money – even without a penalty – will only further delay your retirement savings goal,” Nitzsche said. “Plus, early withdrawals tend to have a negative impact on your tax return.”

The one exception where it would be wise to withdraw from your 401 (k) early during this time without penalty would be if you absolutely needed the funds for basic survival, such as shelter or food. “But it wouldn’t be recommended to take it out to meet non-essential expenses, like credit cards or other loans,” says Nitzsche.

Also consider the opportunity cost of withdrawing your retirement savings during a downturn in the market. To explain, Select spoke with a second expert, Bola Sokunbi, a certified financial education instructor and author of “Smart Girl Finance“on what it might mean to withdraw your savings in the event of a temporary downturn.

“You may experience high losses on your investment and before the possibility of a market rally,” Sokunbi said. “If you have a long time to invest and have access to other options, you should explore it first before a 401 (k) withdrawal.”

What you should do to pay off your credit card debt instead

Looking back, Nitzsche says he would have handled his credit card debt differently, such as contacting specific issuers to inquire about a financial hardship plan or participating in a debt management plan through a credit counselor.

He also recommends using balance transfer credit cards, which allow eligible cardholders to move their credit card balance from one card to another.

If you have credit card debt, this might be a good option as long as you intend to pay off the transferred balance during the card’s interest-free introductory period (usually six months to two years), otherwise you will accumulate more interest on top of that debt.

the Citi Simplicity® Card which offers 0% APR for the first 12 months on new purchases and 21 months for balance transfers (after 14.74% to 24.74% variable; balance transfers must be made within four months of opening Account). To qualify for these longer interest-free periods, you will likely need to have Well Where excellent credit, but options are available for fair credit also.

the Aspire Platinum Mastercard® is one where applicants with fair or good credit may qualify, but the balance transfer period is shorter at just six months. After the introductory period, there is a relatively low variable APR of 9.65% to 18.00%.

Note that depending on your credit, you may not get a credit limit high enough to cover your entire debt balance. And although there are free balance transfer cards, most often require a fee of 2% to 5% (or a minimum of $ 5).

At the end of the line

While paying off your credit card debt is an important step in your overall financial health, there are many ways you can help your credit cards survive an economic downturn like this. Relying on your retirement savings too early may not be the smartest solution. It is better to preserve your retirement funds.

“Sometimes you make the best possible decision based on your values ​​at the time, but looking back, I probably would have handled that part differently just because it took me back several years when it comes to the retirement savings, ”says Nitzsche.

And you can still preserve your same credit score while paying off your debt over time. Nitzsche says his secret to getting and maintaining a high credit rating (even despite his financial difficulties) was always being meticulous about paying his bills on time. Payments on time account for 35% of your credit score calculation.

“Even when things weren’t going well on a monthly basis, even though all I could do was the minimums back then, do them before the due date,” he says. “Set up reminders, whatever it takes to make sure you get at least that minimum.”

Information about the Aspire Platinum Mastercard® was independently collected by Select and was not reviewed or provided by the card issuer prior to posting.

Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.