Creative Commons photo by Flickr user Thomas Hawk.
Paul Solman answers questions from the NewsHour audience on business and economic news here on his Making Sen$e page.
Tuesday’s question comes from an in-house NewsHour staffer who wishes to remain “Anonymous,” not to be confused with the author of “Primary Colors.”
Question: If an emergency situation arises, does it ever make sense to pull money from a retirement fund such as a 401(k) rather than going into credit card debt to keep from going into the red? The fear of short-sightedness is paralyzing.
Paul Solman: As far as I can tell (and readers, please let me know if I’m missing something), the answer is: It absolutely makes sense. I can think of only one situation in which it wouldn’t, sketched below. The important thing to know is that you don’t “pull” money out of a 401(k). You borrow it, penalty free — up to $50,000 or half the value of the account, whichever is lower.
“Uh-oh,” you might be saying. “Don’t all calculations in economics depend upon the ultimate cost? So don’t I have to compare the cost of the 401(k) loan to the cost of borrowing on a credit card?”
Yes, all calculations do depend upon cost, but no, in this case, you don’t need to compare. That’s because when you borrow from a 401(k), as I myself once did years ago for a down payment on our new house before we’d gotten the money from selling the old one, you pay back the interest to yourself. That is, the loan repayments go right back into the 401(k) itself. So the net cost is zero.
There is one situation in which borrowing on a credit card would be (financially) preferable to borrowing from your retirement account: immediately before filing for bankruptcy. If you can cancel any of the credit card debt in bankruptcy — and you can often cancel most of it — you will have borrowed more than you will ever repay. i.e., free money. But let it be clear: Making Sen$e does not recommend this strategy.
By the way, not only is the fear of short-sightedness paralyzing; the cost of regret is real and worth taking into account in cost/benefit calculations. But in this case, once you realize that a 401(k) loan is much better than more credit card debt, there should be self-satisfaction instead of regret. Self-satisfaction is a benefit, not a cost. Thus borrowing from your 401(k) should be even more attractive, in economic terms.
This entry is cross-posted on the Rundown– NewsHour’s blog of news and insight.