Using retirement savings to pay off debt can have an impact on your financial foundation now and in the future.
The average full-time employed American works about 8. 5 hours a day, reads about 12 books a year, spends close to seven hours on screens per day —and has debt. In fact, if you’re like most Americans, you have more than $104,000 that you owe on credit cards, mortgages, student loans, and more.
On the flip side, though, if you’ve started saving for retirement, you may have made good progress. For instance, the typical working family of four adults (ages 45 to 54) with a 401(k) or individual retirement account (IRA) has saved about $115,000.
If you’re trying to get out of debt, those retirement savings are tempting. “We sometimes think, I have these retirement savings at my disposal,’” says Stanley Poorman, financial professional with Principal®. “But that’s there for retirement. There are other tools to use. ”.
In fact, taking money out of your retirement savings to pay off debt might cost you more in the short and long term than you think. Here are some tradeoffs to consider.
Paying off debt is often a top priority for many people, especially as they approach retirement age With interest racking up and balances seeming immovable, dipping into retirement funds can seem like an easy fix. However, this route comes with trade-offs that require careful consideration In this article, I’ll walk through the key factors to weigh when deciding whether or not to use retirement savings to eliminate debt.
The Drawbacks of Withdrawing Retirement Funds for Debt
The most obvious downside is the taxes and fees you’ll have to pay if you take money out of retirement accounts like 401(k)s and IRAs too soon. If you’re under 59% of the retirement age, you’ll have to pay 10% of your income in taxes on top of that. This can really cut into the money you have to pay off debt.
For example, let’s say you need $20,000 from your 401(k) to pay off credit card debt. Assuming a 22% income tax rate, you’ll owe $4,400 in taxes plus a $2,000 early withdrawal penalty. That leaves only $13,600 to actually put toward your debt, over $6,000 less than you withdrew.
That’s not even taking into account the chance that money lost to grow tax-free. You miss out on the benefits of compound interest over the next few years and decades if you take money out of your retirement account now. This can make the money you have saved for retirement much smaller.
Alternatives To Avoid Penalties
If you face a financial hardship, the IRS does allow some alternatives to avoid penalties for certain situations:
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Coronavirus-related distributions—The CARES Act let people take out up to $100,000 without being charged a fee for needs related to the coronavirus. You still owe income tax, but you have up to three years and as many years as you want to pay it back.
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Unforeseeable emergency withdrawals – These apply for events like medical expenses, preventing foreclosure, funeral costs, etc. You pay income tax but no penalty.
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401(k) loans: If you borrow money from your 401(k), you won’t have to pay taxes or penalties as long as you pay it back within 5 years through automatic payroll deductions. While you have the loan, you miss out on market gains.
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Hardship withdrawals – 401(k) plans may allow these for specific circumstances like education, home purchase, or medical expenses. You pay income tax but no penalty.
While these provide penalty relief, they still reduce your retirement savings balance. Hardship withdrawals also cannot be reversed, so proceed with caution.
Impact on Your Overall Financial Plan
It’s crucial to consider how using retirement funds to pay debt now will affect your long-term financial plan. Key questions to ask yourself include:
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Will withdrawing these funds now make it impossible to retire on schedule?
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Do I have enough years left to rebuild my retirement savings?
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What amount can I realistically contribute each month going forward?
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Will paying off debt now only free up a small amount monthly that won’t make a dent in replenishing savings?
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Are there lower-cost debt repayment options like balance transfer credit cards, personal loans, or debt management plans?
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Could I generate more cash flow by reducing expenses in other areas of my budget?
Also think about how debt repayment fits into your overall financial priorities. Would you be better served by focusing any extra money on building emergency savings first, for example? Make sure you take a holistic look at your finances.
When It Might Make Sense
Using retirement funds for debt repayment is generally a last resort. However, some situations where it may be advisable include:
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You have a large credit card balance with an interest rate above 15%. The long-run returns from eliminating such high-cost debt may exceed potential retirement account gains.
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You have a clear repayment plan in place to replenish the withdrawn funds within 2 to 3 years. This helps minimize lost retirement growth. Establishing automatic transfers facilitates repayment discipline.
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You are able to withdraw funds penalty-free based on your age or a special circumstance like a coronavirus-related distribution. Avoiding penalties improves the cost-benefit analysis.
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You have a relatively short remaining working career but sizable high-interest debt. Focusing on debt repayment may make more sense than trying to aggressively fund retirement in a short timeframe.
Even in these cases, proceed with your eyes wide open to the risks and make sure you’ve exhausted other options first.
Dipping into retirement funds to pay off debt can be tempting but should not be done lightly. The taxes, penalties, lost growth, and impact on your financial plan can be significant. While there are certain situations where it may be warranted, it’s generally better to find other ways to repay debt that don’t jeopardize your retirement security. With careful planning and discipline, you can likely find a way to make progress on debt while still saving for the future.
You’ll pay penalties and taxes for using retirement savings to pay off debt.
Every retirement account—a traditional IRA, Roth IRA, and 401(k)—has age distribution limits. That means some combination of penalties and taxes may hit you for early withdrawals.
| Account type | Early withdrawal costs |
|---|---|
| IRA | You’ll get dinged with a 10% penalty on the full amount you withdraw, plus taxes at your current income tax bracket. (Some exceptions to the penalty charge, like using funds for a first-time homeowner down payment, apply.) |
| Roth IRA | It’s important to distinguish between contributions and earnings for a Roth IRA. You can withdraw the former at any time and any age, tax- and penalty-free (remember, you’ve already paid taxes on Roth IRA contributions). If you withdraw earnings at any time, you must pay taxes on them. If you make a withdrawal before the account is five years old, you’ll pay a 10% penalty and taxes. |
| 401(k) | You’ll pay a 10% penalty on the withdrawal plus taxes at your current rate. |
Let’s say that you have $20,000 in credit card debt. Does taking money out of a 401(k) to pay it off really cost anything, and how much will you really see?
| Withdrawal | Subtract your early withdrawal penalty | Subtract your estimated income tax | The withdrawal amount |
|---|---|---|---|
| $20,000 | $2,000 | $4,000 | $14,000—leaving you with $6,000 in your original debt |
You may lose out on potential earnings if you use retirement savings to pay off debt.
If you withdraw that $20,000 to pay off debt, you’re also eliminating the opportunity to grow those funds over the long-term—otherwise known as compounding interest.
“Weigh all the impacts,” Poorman says. “Some impacts you can recover from, and some you may not. Can you really save more for retirement to get back on track? You may be giving up big returns year after year. ”.
Dip Into My 401(k) to Pay Off My $25,000 Credit Card Debt?
FAQ
Is it smart to use retirement to pay off debt?
It is generally not recommended. When you withdraw money from a retirement plan you are creating a debt. The plan will have to be repaid no different than if you borrowed the money from Chase or BoA.
Is it smart to borrow from a 401k to pay off debt?
Generally, it is not recommended to borrow from your 401(k) to pay off debt unless it’s a last resort.
Is it smart to withdraw from IRA to pay off debt?
However, using money from an individual retirement account (IRA) can have major consequences. Doing so depletes your savings, foregoes future capital gains, and can lead to serious tax implications. Consider alternatives before taking this extreme step to paying off your credit card balances.
Is it better to be debt free or have a 401k?
Should I pay off all my debts before I start saving for retirement? In general, it’s not a good idea to pay off all your debts before you start saving for retirement. A balanced approach will usually let you deal with high-interest debt while still getting long-term investment growth and employer contributions.