Should I use my 401(k) to pay off high interest credit card debt?
I have $407,000 in my 401(k). My husband has $250,000 in his 401(k). I am 5 years away from retiring from the federal government, at which time I will also have a pension of approximately $40,000 annually. My husband is 8 years away from retirement. I invest 10% into my 401(k) and so does my husband.
I have $43,000 in credit card debt with 9%-15% interest rates. I am exploring 2 options for paying it down:
1) use my 401(k) at 2% interest over 3 years. With this, I would pay approximately $750 in interest and stop using my credit cards so I can be debt free at retirement.
2). use the "Zilch" system that assist with paying the debt. This would cost thousands in interest and more than 3 years time with this much debt so I would go into retirement with debt.
Our house will be paid off in 8 years which will free up $2000 monthly and I plan to increase my 401(k) contribution to 15%. Is using my 401(k) a good idea?
Paying off a debt with 9-15% interest (Which incidentally is quite high) is like getting a guaranteed return of 9-15% on your money- therefore it is highly desirable that you pay it off. While, your 401K balance could earn you similar or higher returns depending on your asset allocation, there is no guarantee.
You can get a home equity loan at a lower rate depending on various factors- this has a tax advantage as you can possibly deduct the interest against your income while still participating in an appreciation of your home. You can pay off the loans instead of contributing to your (and possibly your husband's) 401K - while this is less than the value of your debt it is a better option than taking a 401K loan. You may also want to see if you can reduce other expenses at least temporarily until your debt is paid off.
I like the way you are thinking about your situation- you've done your homework on TSP loans and are trying to look at your comprehensive picture.
Though generally, many financial planners and advisors will warn against taking 401(k) loans, being a federal employee you are in a unique situation from others when it comes to planning for retirement because of your pension provides a guaranteed minimum income stream. This means that your TSP/ 401(k) might not be needed to provide significant income from day 1 of retirement.
Additionally, the interest rates you are paying the bank are at least 4x higher than the G-fund rate. Even if you are in the L-2020, the interest you've made over the last year on that $43,000 has been less than what you've paid over the last year on the credit cards, making it a NET LOSS.
While one or the other could make a good argument, because both are present I wouldn't hesitate to tell you to take the TSP loan. It will provide better cash flow because of the lower interest rate, a lower interest cost, and you'll pay yourself the interest! Finally, though you are removing the money from the market, any comparable gains would likely not outweigh interest costs given your lower risk tolerance owing to your proximity to retirement.
Feel free to reach out with any more specific questions or clarifications through a private message.
Congrats on almost getting to retirement! There are different schools of thought on this issue - and you have to weigh the pros and cons. So let's go through some of the big ones - and some considersations.
1) Lowering your interest and paying it to yourself is a good thing - but if you choose to leave early that loan can become problematic as it will count as a distribution which you will have to pay taxes on.
2) You could be missing out on growth if this market continues to rally - on the other hand if we see a pull back taking a loan now isn't such a bad idea.
Sooo what should you do?!
You mentioned you are almost done paying off your house so it sounds like you have a good amount of equity there. I would probably suggest you explore getting a home equity loan/line of credit and use that to pay off your debt. Your rate should be substantially lower than your credit cards - possibly 3-4.5%, you won't have to touch your retirement and you will get a tax deduction on the interest assuming you itemize.
Just remember - using your home as an ATM is not a good thing so be sure to put those cards away if you go down this route. As you are right to focus on being out of debt before retirement.
Tom Cymer CFP
President Opulen Financial Group LLC
It sounds as though your 401(k) will allow you to take out a loan. If so, then you can borrow up to $50,000 at nominal interest (Prime rate which is about 4.25%). You will need to make quarterly payments and you will have to pay off the loan in 5 years. If this is the case, then by all means, take out the loan, pay off the credit cards and continue to work toward a positive retirement. Afterall, you will be paying interest to yourself (which is an advantage) instead of the banks.
Your thinking is right on target with one caveat. I'm assuming you're going to borrow from the 401(k) plan other than make a taxable withdrawal and if this is the case, that's how I would approach paying off your credit cards. When you do, consider keeping one card with the largest line you have and destroying the rest rather than setting them aside. The fact that you have $43,000 in debt is not a good sign and I'd hate to see it happen again. Coincidentally, your planned retirement and the complete repayment of your mortgage are reasonably close and they should also be targets for full retirement between the two of you. Going into retirement with no mortgage and therefore no interest deduction may cost you a tiny bit in taxes, but in cash flow, you will be way ahead. The unspoken benefit is the psychological advantage of having no mortgage and please don't underestimate its value. Finally, do whatever you can to increase the 401(k) contributions for both of you through retirement and consider the possibility of locating a fee-only financial advisor in your community for pre-retirement planning. You can find these advisors who sell no products at the following website: www.napfa.org I hope this helps and good luck.