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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

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If you are near retirement or have already retired, you don't want debt hanging over your head. But if you haven't been able to pay off those nagging credit card bills, you may be wondering if you should dip into retirement money to rid yourself of those debts.

spinner image When to take money from your retirement fund and repay a debt- money under lock and key
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See also: Saving vs. Paying debt

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In most cases, it's a bad idea to drain your 401(k), IRA or other retirement assets to eliminate credit card obligations. That's because if you're under 59 ½ years of age, you could face a 10 percent tax penalty plus have to pay ordinary income taxes on any amount you withdraw.

Still, there is one time when it probably is a good idea to use retirement money to pay off high-rate credit card debt: It's when you're still working, and can borrow money from an employer-sponsored retirement plan — and then repay the money to yourself without tax consequences.

Let me explain why this could be a good idea and how to go about it.

Assume you owe $20,000 in credit card debt at a 15 percent annual interest rate.

For every year you let that debt lingers, you're forking over $3,000 in interest payments alone to a bank. That $3,000 translates into you making the bank $250 richer and yourself $250 poorer every single month.

So you'd be wise to consider tapping your retirement money to pay off those credit card bills.

The question is: how should you go about doing this? Your choices really boil down to two options: You can take a distribution or you can borrow money from the retirement plan.

Don't Take a Distribution, Take a Loan

As mentioned, early withdrawals have serious tax ramifications. So a distribution is not the preferred strategy. Plus, taking money out of your 401(k) permanently means that you lose out on the chance for those funds to grow over time — which is the whole point of stashing away money into your retirement nest egg. You want those funds to appreciate over the years and to be there for you once you stop working.

So again, the borrowing route is more desirable, because it will force you to replace the money you take out.

But if you've already retired, you can't borrow money from an employer-sponsored retirement account, such as a 401(k), 403(b) or 457 plan. So this strategy will only work for people who are still gainfully employed and whose retirement plans at work permit borrowing.

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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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