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Don't use your 401(k) to pay off credit card debt, says 'credit junkie' with an 800+ score who tried it once

The new coronavirus stimulus package will allow Americans to withdraw from their 401(k), penalty-free. Here's why you shouldn't do so to pay off credit card debt.

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The $2 trillion stimulus package, also known as the Coronavirus Aid, Relief and Economic Security Act (CARES Act), aims to delay federal student loan payments and send a $1,200 relief check to many Americans. It will also allow people to withdraw up to $100,000 from their retirement savings with no penalty fee.

It may sound tempting if the coronavirus pandemic put you in a financial bind, but Thomas Nitzsche, a financial educator at Money Management International, Inc (a 501(c)(3) nonprofit member of the National Foundation for Credit Counseling), doesn't recommend tapping into your retirement savings to pay off credit card debt — penalty-free or not.

Why Nitzsche used his 401(k) to pay off credit card debt

Nitzsche speaks from experience. He is 40 years old now and a self-proclaimed "credit junkie" with a credit score over 800, but in 2008 when he was in his twenties and laid off from his job, he was burdened with having to pay a mortgage on a new home, just over $20,000 in student loans and over $10,000 in credit card debt.

He made some lifestyle changes, such as having three others live in his St. Louis, MO, home at the time to split mortgage and utility payments. But one of the biggest decisions he made was completely tapping into his retirement savings — what he estimates was about $20,000 at the time — to pay off his credit cards. Nitzsche tells CNBC Select that it was a decision he likely would not make again.

"That decision was largely done out of just panic and prioritizing," Nitzsche says. "I knew that I wanted to do everything possible to stay in good shape to keep my home because I had just bought it a year before and obviously had a lot of pride in home ownership."

But now that over ten years have passed, Nitzsche is still feeling the effects of his decision, and he's not sure he would encourage someone in a similar scenario to do what he did.

Why he doesn't recommend you do an early withdrawal

Looking back, Nitzsche says that liquidating his 401(k) to pay off credit card debt is something he wouldn't do again.

"It is so detrimental to your long-term financial health and your retirement," he says.

Many experts agree that tapping into your retirement savings early can have long-term effects. It can put you at risk later on in life when you are older, not working and would otherwise need to rely on those funds.

There are also short-term effects from making an early withdrawal from your 401(k) as well: It doesn't come free. Doing so has costly consequences, including both a penalty fee and taxes. For borrowers 59½ years old and younger, there is generally an early withdrawal penalty of 10%, plus taxes, which can be anywhere from 20% to 25% depending on your income and tax bracket.

If you are someone who is cash-strapped during this time of uncertainty, tapping into your retirement savings is an option of last resort. "That really should not have been touched and not something we would usually advise somebody to do," Nitzsche says. 

What about penalty-fee withdrawals from your 401(k)? 

Even in the case of the recent stimulus package, which relieves Americans of the penalty fee when withdrawing from their 401(k), there are still taxes that will be applied.

"Many of us have already seen a significant drop in our 401(k), and taking money out — even without the penalty — will only further set back your retirement savings goal," Nitzsche says. "Plus, early withdrawals tend to negatively impact your tax return."

The only exception when it would make sense to withdraw early from your 401(k) during this penalty-free period would be if you absolutely needed the funds for basic survival, such as for housing or food. "But it wouldn't be recommended to take it out to satisfy non-essential expenses, like credit cards or other loans," Nitzsche says.

Consider also the opportunity cost of withdrawing your retirement savings during a market decline. To explain, CNBC Select spoke to a second expert, Bola Sokunbi, a certified financial education instructor and author of "Clever Girl Finance," about what pulling out your savings in a temporary downturn could mean.

"You may be taking high losses on your investment and before the chance of a market recovery," Sokunbi says. "If you have a long investing timeline and access to other options, you should explore that first before a 401(k) withdrawal." 

What you should do instead to pay off your credit card debt

In hindsight, Nitzsche says he would have handled his credit card debt differently, such as reaching out to the specific issuers to inquire about a financial hardship plan or participating in a debt management plan through a credit counselor.

He also recommends using balance transfer credit cards, which allow qualifying cardholders to move their credit card balances from one card to the next.

If you have credit card debt, this could be a good option as long as you have a plan to pay off the transferred balance within the card's introductory no-interest period (typically ranging six months to two years), otherwise you accrue more interest on top of that debt.

The Citi Simplicity® Card that offers 0% APR for the first 18 months on purchases and balance transfers (after 14.74% to 24.74% variable). To qualify for these longer interest-free periods, you will most likely need to have good or excellent credit, but there are options available for fair credit as well. 

The Aspire Platinum Mastercard® is one where applicants with fair or good credit may qualify, but the balance transfer period is shorter at only six months. After the intro period, there's a relatively low variable APR of 9.65% to 18.00%.

Note that depending on your credit, you may not get approved for a credit limit high enough to cover the full balance of your debt. And while there are some balance transfer cards with no fee, most usually require a 2% to 5% fee (or a $5 minimum).

Bottom line

While paying off your credit card debt is an important step in your overall financial health, know that there is more than one way to help your credit cards survive an economic downturn like this. Relying on your retirement savings too early may not be your smartest solution. It's best to preserve your retirement funds.

"Sometimes you make the best decision you can based on what your values are at the time, but in hindsight, I probably would have handled that portion of it differently just because it did set me back several years as far as retirement savings went," Nitzsche says.

And you can still preserve your credit score even while paying your debt off over time. Nitzsche says his secret to getting and maintaining a high credit score (even through his financial hardships) was always being meticulous about paying his bills on time. On-time payments counts as 35% of your credit score calculation.

"Even when things weren't great on a monthly basis, even if all I could do was the minimums at the time, make them by the due date," he says. "Set up reminders, whatever it takes to make sure you at least get that minimum."

Information about the Citi Simplicity® Card and Aspire Platinum Mastercard® has been collected independently by CNBC and has not been reviewed or provided by the issuer of the card prior to publication.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.