Don't touch the 401(k)

Stephen asks if it would be a good idea to take out a loan against a 401(k) to pay off credit card debt. Dave advises against this, and during the conversation he learns that credit card debt isn't the real problem.

QUESTION: Stephen and his wife have about $12,000 in credit card debt, and they owe another $80,000 in student loans. Their kids’ education also runs about $1,000 a month, all on a combined yearly income of $100,000. He calls in to ask Dave if it’s acceptable to take a loan against your 401(k) to clean up the credit card mess. Dave doesn’t like the idea, and he explains why it’s a bad plan.

ANSWER: I don’t recommend that you do that, and here’s why. Your 401(k) should be invested in good mutual funds. When you take the money out in a loan, they pull it out of the mutual funds and you’re paying yourself a five percent interest rate instead of receiving what the mutual funds are paying, which should be 10, 12, 15 percent — whatever the market is doing. So you’re missing out on good rates of return.

But that’s not the biggest reason. The biggest reason is when you leave your company, and you will leave — whether it’s when you get a better job, get fired, or you die — that loan is considered an early withdrawal. If you don’t repay it within 60 days, you get hammered with a 10 percent penalty plus your tax rate. It can end up being half of the account.

No, I wouldn’t do that. The good news is that it’s only $12,000. I would tighten up the budget, and do something to increase your income — have a big garage sale, and sell so much stuff the kids think they’re next. The $80,000 in student loans is what’s killing you, not the credit card debt. You need to work a serious plan to get out of debt, and that always includes living on a tight budget.