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Dear Liz: I will be 61 in December. I have $15,000 in credit card debt at 9.9% and $41,000 in a certificate of deposit earning 3% per year. I have $590,000 in my 401(k) account. I want to pay off the credit card balance to redirect my income to paying off my $26,000 mortgage by the end of 2013. Which near-term option for paying off the credit card is better: close the CD and buy a new, lower-paying CD with the balance after paying the card off, or take a 401(k) distribution, leaving the $41,000 emergency fund untouched?

Answer: Since you’re older than 591/2, you would not have to pay penalties on any withdrawal from your 401(k). But a withdrawal would still be a bad idea for a number of reasons.

The most obvious is that you would have to pay taxes on any amount you take out. Typically 20% is withheld from any distribution, but your bill could well be higher depending on your federal and state tax brackets. In the 25% federal and 8% state brackets, you’d owe $3,750 in federal and $1,200 in state taxes on a $15,000 withdrawal. So even without penalties, you’d lose one-third of a withdrawal to taxes.

The money you take out also wouldn’t be able to earn any future tax-deferred returns for you. At 60, you have a life expectancy of a couple more decades. The money you plan to withdraw potentially could grow to more than $70,000, assuming 8% average annual returns, if you leave it alone.

So using 401(k) money to pay debt is almost as dumb for you as it would be for a younger person who would pay penalties and incur an even bigger potential loss of future tax-deferred money.

Use the CD money instead, and change your spending habits so you don’t incur any future credit card debt.

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1 Comments

1

Using his savings to pay off the debt is not necessarily the best choice, and therefore using the funds in his 401(k) is not necessarily dumb.
He is old enough that he will not have to pay penalties on any withdrawals, but he is going to have to pay the taxes on the withdrawals whether he withdraws now or 20 years from now, and the earnings in the 401(k) are only tax-deferred, not tax-free. The tax deferral will make keeping money in his 401(k) come out better, but ony if tax rates do not go up.
An increase in the tax rates can easily tip the scales the other way. Since there is a good chance tax rates will go up next year or in the next 10 or 20 years, using his 401(k) now to pay off the debt is not a dumb choice but a reasonable bet that tax rates will go up.