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Pay Down Your Debt Challenge

The One Time You Can Use Retirement Money to Pay Off Debt

Most of the time it's not worth raiding your nest egg, but this loan can be the exception

OK, back to our example. You've got $20,000 worth of credit card debt and that 15 percent interest isn't making it any easier to pay off.

Your credit card company only requires that you pay 2 percent of the outstanding balance each month. In other words, your required minimum payment is $400 per month. At that rate, you'll pay off your $20,000 balance in 6 years and 7 months. And over that time, you'll pay a total of $11,577 in interest.

To avoid this scenario, take a loan from your retirement plan at work, but only if:

  • You can set up a repayment plan that is three years or less
  • You reasonably confident that you will remain with the same company during that three-year period

The reason you want to limit the time your loan is outstanding is two-fold. First, the sooner you repay the funds, the quicker they can begin earning interest again. Equally important, though, you want to repay that loan as soon as possible to reduce the risk associated with you leaving the company for some reason.

When you separate from an employer for any reason — including termination or just you getting a different job — any outstanding retirement loans generally come due. Sometimes, you'll have 90 days or so to repay the loan in full. The specifics depend on your company's retirement plan. But any funds not repaid within a brief, specified time period are typically treated as taxable distributions to you.

You want to avoid the IRS taxing you on any money you take out of a retirement plan for the purposes of reducing debt. And a loan from your retirement plan can be the smart way to do just that.

With a 401(k) or 403(b) loan, you pay yourself back the money you borrowed plus you repay yourself interest too. Best of all, the loan immediately gives you the economic benefit of quickly reducing that high interest rate credit card debt that's draining you financially.

Lynnette Khalfani-Cox, The Money Coach®, is a personal finance expert, television and radio personality, and a regular contributor to AARP. You can follow her on Twitter and on Facebook.

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