Ask The Money Coach

Posts Tagged ‘early withdrawals’

I don’t think it would be a good idea to tap your 401(k) to pay off that high rate credit card debt because it would be very costly to do so. For starters, since you are under 59 ½ years of age, that 401(k) distribution would be considered “premature” by the IRS. This means your $10,000 would be subject to ordinary income taxes – along with a 10% penalty by the IRS. I don’t know what tax bracket you are in currently. But let’s assume you are in the 25% tax bracket. You would have to pay the federal government $2,500 in ordinary income taxes, plus a $1,000 penalty. So all in all, your $10,000 is effectively reduced to $6,500 – because you’ll have to fork over $3,500 to Uncle Sam. That’s the equivalent of paying 35% interest (in the form of taxes) in order to access that $10,000. That’s too high a price to pay. I know you want to get rid of that high-rate credit card debt. But I’d recommend using some savings (not retirement savings), or finding an alternative source of cash to pay the credit card debt. If that’s not possible, try two other strategies: Call your credit card company and ask for a lower rate. Depending on your payment history, they may say yes. Also, start tripling the payments you’ve been paying on your credit card. If you can be even more aggressive, using some of the pension income you receive from your former employer, that will knock out your credit card debt even faster.

I usually don’t like to see people use their 401(k) assets to pay off credit card debt because doing so shrinks a person’s retirement nest egg and most people face serious tax consequences by making early withdrawals from their retirement plans. In your case, however, you are already a year or two away from retirement, so it makes sense to aggressively pay down that credit card debt so that it’s not hanging over your head while you are working. Read on for more financial reasons why this is a smart strategy for you.

Tax Free Withdrawals

Also, only individuals who are under 59 ½ years of age have to pay tax on the amount withdrawn, plus a 10% penalty for making an early withdrawal from their 401(k) plans. In your case, however, since you are already 61 years old, you would not be subject to that 10% penalty, making the prospect of paying off your credit card debt an even more financially sound decision. In fact, there is an exception in the law that allows penalty-free distributions from your 401(k) provided you are 55 or older when you leave your job.

A Good Rate of Return

Lastly, paying down your credit card bills will generate an effective return rate that’s not likely to be matched by your retirement investing plan. In other words, you may be paying 15% or so interest rates on those credit cards. Therefore, that’s the return you’re essentially getting by paying off that consumer debt. Chances are your 401(k) is not earning 15% a year. So go ahead, feel comfortable in your choice to tap that 401(k) money and clear away that credit card debt. It’s a wise decision. Just be sure to manage you credit wisely in the future and avoid running up those credit card debts again during your Golden Years.