Should you use retirement savings to pay off debt?

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Balancing saving for retirement and paying off debt can feel like a financial tightrope walk. Eliminating debt can bring immediate financial relief, but dipping into your 401(k) or IRA to do so can jeopardize your future financial security. While the idea of becoming debt-free might be appealing, tapping your 401(k) or IRA is generally a bad idea.

Here’s what you need to know.

Should you use retirement savings to pay off debt?

Using retirement savings to pay off debt is a decision that should not be taken lightly. It’s true that paying off high-interest debt can save you money in the long run, but you also have to consider the potential loss of future investment growth in your retirement account. Additionally, early withdrawals can trigger penalties and taxes, reducing the amount you have to pay off your debt and potentially putting you further behind in your retirement savings.

How much could a move like this cost you? Consider this example.

Imagine you have $100,000 in your 401(k), and you’re considering withdrawing $20,000 to pay off debt. If you’re in the 25 percent tax bracket and you’re under 59 ½ years old, you’d pay a 10 percent early withdrawal penalty. This means you’d lose $7,000 to taxes and penalties, leaving you with only $13,000 to pay off your debt. And if you withdraw funds from your 401(k) due to hardship, you may be prohibited from contributing to your retirement plan for at least six months, further restricting your ability to rebuild your savings.

That’s not all. Imagine your 401(k) earns an average annual return of 7 percent, in 20 years, the $20,000 you withdrew could have grown to nearly $77,000. So the real cost of your withdrawal is not just the $20,000 you took out, but also the potential future growth you missed out on.

In short, early withdrawals can stunt your investment growth and lead to a smaller nest egg when you retire. That could leave you with some hard choices, like continuing to work and delaying retirement.

When does it make sense to use retirement savings to pay off debt?

While raiding your retirement account to pay off debt is generally a bad idea, there are a few situations when it might make sense, depending on your financial situation. Here are some examples:

• If you’re nearing retirement and your debt is causing significant financial and emotional stress.

• If you have high-interest debt that is growing faster than your retirement investments.

• If your total debt is reasonably small and can be repaid quickly without significantly impacting your retirement savings.

• If the immediate relief of debt repayment outweighs the long-term benefits of keeping your retirement savings intact.

What are the tax and penalty implications of using retirement savings to pay off debt?

Withdrawing funds from retirement accounts before the age of 59 ½ can trigger both taxes and penalties. For traditional 401(k)s and traditional IRAs, you’ll typically owe income taxes on the amount withdrawn, along with a 10 percent early withdrawal penalty. In certain situations, you might be able to avoid the penalty — but not income taxes — if you qualify for a hardship or penalty-free withdrawal (more on that below).

Roth IRAs offer a bit more flexibility, allowing you to withdraw your contributions tax-free and penalty-free at any time (so long as you’ve owned the account for at least five years). However, withdrawing earnings from a Roth account before age 59 ½ still results in a 10 percent penalty.

Penalty-free 401(k) and IRA withdrawals

While withdrawals from a 401(k) or traditional IRA before age 59 ½ are generally subject to a 10 percent early withdrawal penalty, there are certain circumstances where the penalty can be avoided. According to the IRS, you’ll need to demonstrate an “immediate and heavy financial need.”

These include:

1. Certain medical expenses

2. Costs relating to the purchase of a principal residence

3. Tuition and related educational expenses

4. Payments necessary to prevent eviction from, or foreclosure on, a principal residence

5. Burial or funeral expenses

6. Certain expenses for the repair of damage to your home

Certain natural disasters may also qualify you to take hardship withdrawals.

However, it’s important to note that avoiding a penalty does not mean the distribution is tax-free — ordinary income taxes still apply. And certain employers may prevent you from adding to the plan for at least six months after the withdrawal, which can be particularly impactful if you’re unable to take advantage of a company match.

401(k) loans

If you’re set on tapping your retirement account to pay off debt, taking out a 401(k) loan might be a better move than taking a hardship withdrawal.

A 401(k) loan allows you to borrow against your retirement savings and pay yourself back over time with interest, without incurring taxes and penalties as long as it’s repaid according to the plan’s terms.

While it’s relatively standard for plans to permit 401(k) loans, it’s not a universal feature, so you’ll need to check if your employer offers it. Even when these loans are available, you’ll need to adhere to certain guidelines, or you could face penalties or taxes. For example, loans must be paid back within five years (unless borrowing for the purchase of a primary residence), and you’ll be required to make regularly scheduled repayments during that time, typically through payroll deductions.

Benefits and drawbacks of using retirement savings to pay off debt

There are both benefits and drawbacks to using retirement savings to pay off debt, and it’s crucial to weigh these before making a decision.

Pros
Paying off high-interest debt: If your debt carries a high interest rate, using your retirement savings to pay it off could save you money on interest charges.
Improve your credit score (eventually): Paying off your debt can help improve your credit score over time.
Reestablishing financial stability: If your debt is causing significant financial stress, paying it off using your retirement savings might bring you some relief.

Cons

• Taxes and penalties: Early withdrawals from retirement accounts can trigger income taxes and possibly a 10 percent early withdrawal penalty.

• Loss of investment growth: The money you withdraw will no longer grow through compound interest, which can significantly impact your retirement savings in the long term.

• It’s a short-term solution: While paying off debt can bring immediate relief, it doesn’t address the underlying issue that led you here in the first place. Without a plan to avoid future debt, you could find yourself back in the same situation.

What you can do instead

If you’re wary of dipping into your retirement savings to pay off debt, there are alternatives you should consider.

1. Debt consolidation: This involves combining all your debts into one loan with a lower interest rate, making it easier to manage your repayments and potentially saving you money on interest.

2. Balance transfer credit card: Some credit cards offer zero percent introductory interest rates on balance transfers. This can provide temporary relief from high-interest debt, but it’s important to pay off the balance before the promotional period ends to avoid high interest rates.

3. Negotiating with creditors: Sometimes, creditors are willing to negotiate lower interest rates or a repayment plan that fits your budget.

4. Filing for bankruptcy: No one likes the idea of filing for bankruptcy. But if you go this route, the funds in your 401(k) are protected. Because assets can’t be easily liquidated like a savings account or an extra car, your retirement account can’t be used to pay back your debts during bankruptcy. You should always speak with an attorney before starting the bankruptcy process.

Bottom line

While using retirement savings to pay off debt can provide short-term relief, it’s essential to consider the long-term impact on your financial health. Weigh the pros and cons, explore alternatives and consult with a financial advisor to make an informed decision. Remember, your retirement savings are meant to secure your financial future, and preserving them should be a top priority.