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Should I cash out my 401(k) to pay off debt?

June 29, 2011: 5:05 AM ET

I'm 28 and have about $4,000 in debt on different credit cards, all with rates in the upper teens. I'm not charging more—the debt was due to a one-time event—and I'm changing jobs soon. Does it make sense to cash out my 401(k) (which holds about $5,800) to pay off the cards? —Name withheld upon request

Taking money out of a retirement account early is almost never a good idea, says Ann Garcia, a financial planner with Maas Capital Advisors in Portland, Ore. In your case, it doesn't make sense for several reasons. First of all, after paying taxes and penalties, you probably wouldn't wind up with enough money to fully pay the debt. And you'd lose your nice start on a retirement nest egg. Though $5,800 may not seem like a huge amount, left untouched it will be worth as much as $85,000 in retirement, calculates Garcia.

A better strategy: Do your best to increase payments on your credit cards. You're already on track because you aren't piling on more charges. Say you're paying $125 a month now on your cards. If you increased that to $225, you'd retire your debt in two years instead of four and save about $800 in interest payments. Each time you get a pay increase—such as when you start your new job—put the extra amount into paying off your cards faster. (You may have a waiting period in your new job before you are allowed to start contributing to a 401(k) or other employer-sponsored retirement account. During those months, put the money you would be contributing to your 401(k) toward your debt.)

Finally, call your credit-card issuers and ask them to lower your rate. One of them may be willing to do so if you consolidate all your balances on that card. A caveat: Be careful of teaser rates if you go this route. Your card company may guarantee a lower rate for a limited period of time, then raise the rate afterwards. Be sure you can pay off the debt during the low-rate period before consolidating.

-- Walecia Konrad

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