Q&A: Is it OK to tap my 401(k) to pay off Credit Card Debt?

When I wrote “The Recession Diaries” column at the Chicago Tribune and later for AOL.com, I loved responding to mail because questions raised by one reader often reflect the dilemmas of many.I recently received this letter from one reader, Nick from Michigan:

“I have a question regarding credit card debt and I was hoping to hear some suggestions. I am one year removed from college and have a good paying job and so does my wife. We both live within our means and don’t spend too freely. However, I have roughly $12,000 in credit card debt and haven’t been able to knock that down too much because we were self-financing our wedding and I just haven’t had the free money to put towards credit card debt. This has been weighing on me for quite some time and I just hate having that feeling. I want it gone!!!

When I was in college, I interned 3 years for a company that offered a great 401(k) program that I took advantage of. So between that and my current job, I have $20,000 saved in my 401(k). Would it be wise to take out $12,000 from that 401(k) to pay off my credit card debts? The benefits I see in doing that are as follows:

  1. Freedom from credit card debt! This would be a huge relief.
  2. It would raise my credit score. (We’ll be looking to buy a house in the not-too- distant future).
  3. It would lower my monthly expenses, so I could then pay more into my 401(k) to build that back up.

Obviously, I know there are penalties and taxes associated with early withdrawal, but I think the benefits may outweigh that. Any thoughts?”

I shared Nick’s letter with some very respected people in the finance industry whom I’ve gotten to know over the years. Here’s some of what they advised, along with my own suggestions based on my time as a personal finance writer.

Experts: Leave the 401(k) be

“Here’s what I think they need to do: Pretend it’s a three-year car loan,” says Lynn Ballou, managing partner of Ballou Plum Wealth Advisors, LLC in Lafayette, Calif.”Get this debt onto the lowest interest rate [credit] card or credit union type loan possible. Then figure out how much to pay each month for three years to get it paid off. Cut back spending during that three year time to handle the additional hit. About $750 per month at 20 percent interest and it’s paid off in three years. Better, about $600 per month pays it off in three years at 6 percent.”

“DO NOT take money out of your 401(k) to pay down this debt,” says Susan Beacham, founder of the financial literacy website Money Savvy Generation. “Aside from the penalties you will incur if you withdraw this money, you are giving up the power oftax-free investing over the coming 30 to 40 years. At your age, a nest egg does not sound as sexy as it will to you and your spouse when you are in your 50s. But trust me, later in life you will be grateful you did not withdraw this money – but rather, let it grow. This nest egg, grown over the years, will provide you with an enormous senseof financial security right when you need it most. Meanwhile, get a second job to pay off that $12,000. Do you have a talent that others would benefit from? Think about it. You could be sitting on a $12,000-plus goldmine of talent!”

My advice

And my suggestion to Nick? Tackling the debt stems first and foremost from how you think about it. While it seems oppressive to have a $12,000 albatross around your neck, you’ve also got this blessing: You and your wife both hold down jobs with decent pay. Taking money from your 401(k) isn’t wise, because the big payoff comes with compound interest built over time. That $12,000 now could yield millions by retirement age if you leave it alone.

Your debt didn’t come from left field; you paid for a worthwhile milestone event, your wedding. Since you and your wife live within your means (and have no big weddings in your immediate future), sit down and calculate how much you can pour into extra debt relief every month. My guess is you can easily pay off this debt within 18 months, assuming roughly $700 month to cover principal and interest, and no new debt snowballs in between.

You will learn patience with this approach, and something more: Working at an important goal together. Money issues often create rifts between couples that never mend. Here’s your chance to turn a money challenge into a bonding experience, and a page for your marriage playbook.