I recently heard that a co-worker used some of his 401k money to pay off a credit card. I am 27, and have $11,000 in credit card debt. Should I do the same?
~ Katie M
GACK! NO. And here's why: It will cost you a fortune.
Money you withdraw from your 401k before the age of 59 1/2 is called an early withdrawal, and the IRS doesn't like that. You would pay a 10% penalty, on top of owing state and federal taxes on that money.
(Remember: Your 401k contributions go in tax-free, but you owe taxes whenever you withdraw them.)
Depending on where you live, that means you could lose, say, 30% of your money or more; i.e. that $11,000 would get knocked down to $7,700—possibly less.
Bottom line, you would have to withdraw approximately $16,000 to net the $11,000 you'd need to pay off your card.
But wait, there's more!
You could take out what's known as a 401k loan—although you're just borrowing from yourself. The advantage is that you wouldn't get hit with the 10% penalty, and you wouldn't have to pay taxes.
Assuming your employer allows 401k loans, the amount is often limited to half of your vested balance, up to $50,000, or some other restriction. And, if you were to lose your job or quit, you'd have to repay the loan immediately, typically within 60 days. (If you defaulted, you'd have to pay taxes and the 10% penalty.)
Either way, the loan must be repaid, generally within five years, and you would owe yourself interest!
But the real reason not to borrow from yourself is that you're sucking money out of your future. That $16,000, in addition to your other contributions, would grow immensely over time. It's difficult to give you a firm figure, because I don't know how much money you've saved or what your contribution rate is, but use the 401k calculator at bankrate.com— and then just pay off your credit card the smart way, with cash out of pocket.
Here's more on common 401k planning mistakes and tips to avoid them.