401k Basics

• Employees can elect to have part of their earnings placed into 401k tax-deferred retirement accounts, and many companies make matching contributions. When you withdraw funds, you must pay income tax on the contributions and the earnings, and if withdrawals are made prior to age 59 1/2, you must also pay a 10 percent penalty tax. If you are currently employed and are over the age of 59 1/2, you can withdraw money from a 401k and use it to pay off your credit card. If you are younger than 59 1/2, you cannot access the funds unless you have a 401k account held with a former employer, in which case you can pay the taxes and cash in that account.
  
  

Taxes Versus Savings

• Income tax brackets in the United States range from 15 to 35 percent. If you cash in a 401k from a former employer prior to age 59 1/2, you must also take into account the additional 10 percent penalty, which means you pay between 25 and 45 percent in total taxes on the withdrawal. Depending on the interest rate you are paying on your credit card, you may end up paying more in taxes to access the money than you would save in future interest payments by paying off the card.
  
  

401k Loans

• Companies are not required to offer 401k loans, but if they do, the interest and principal payments you make on your 401k loan are paid back into your own account. The 401k loan interest rates are normally based on U.S. prime rate, whereas credit card rates are based on prime rate plus several percentage points. Therefore, you typically reduce your interest expenses by using a 401k loan to pay off your credit card debt. Normally, you can borrow up to the total amount you have invested in a plan, but not the company matching contributions.
  
  

401k Downside

• When you take money out of your 401k, that money cannot grow. So, while you are able to reduce your short-term debt payments, you also reduce your ability to save money for retirement. Additionally, if you leave your job while you have an outstanding loan, you must either pay back the entire loan amount or cash in the rest of your 401k and pay taxes on the entire distribution. You have reduced your monthly debt by paying off the credit cards, but you have also wiped out your retirement fund.