Don’t raid 401(k) to pay plastic debt

Dear Dr. Don,
We have $26,000 in credit card debt at 5.9 percent fixed. Our payments are about $400 per month. This is taking a big chunk out of our monthly budget in these tough times — not to mention the stress hanging over our heads.

Should we take a
401(k) distribution to pay it off? This would leave us with only $20,000 in our
401(k). We are in our late 40s and for the next 12 months we will be unable to contribute to our employee
401(k) due to child support payments. We plan to maximize our contributions after they end next year. Please help!

Mary Mitigate

Dear Mary,
If the
401(k) funds are with your current employers, you’re limited to a hardship distribution or a plan loan. The plan loan has its own set of payments, so it’s not likely to provide any relief in your monthly budget. Not all
401(k) plans offer plan loans.

The Bankrate feature, ”
401(k) hardship withdrawals on the rise
,” lists six IRS-approved hardships.

6 IRS-approved hardships
Expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care.
Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments).
Payment of tuition, related educational fees, and room and board expenses for the next 12 months of post-secondary education for the employee, or the employee’s spouse, children or dependents.
Payment necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
Funeral expenses.
Certain expenses relating to the repair of damage to the employee’s principal residence.

If you qualify for a hardship withdrawal under one of these six hardships, you’ll still owe income taxes and a 10 percent penalty tax. If you’re in the 25 percent marginal federal income tax bracket, that means you would need about $40,000 to pay off $26,000.

Does that still leave you with $20,000 in your

You can argue that the income tax would come due sooner or later, but paying $4,000 in a penalty tax to pay off the $26,000 debt would create more stress in my world than making a $400 credit card payment.

There are exceptions to the penalty tax for a hardship withdrawal. The exception that may fit your situation is a distribution from a qualified retirement plan (other than an IRA account) to an alternate payee under a qualified domestic relations order.

You will need professional tax and possibly legal advice to know for sure if you can pay the child support out of the
401(k) as a hardship withdrawal that is exempt from the penalty tax. See IRS Publication 575, ”
Pension and Annuity Income,” for more information.

You have your credit card debt at a very competitive interest rate. Ask yourselves if the need to free up $400 a month in the household budget is worth depleting your
401(k), if in fact you can get a distribution out of the account. This should be a last resort.

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