Over the years I’ve been asked on a number of occasions if it is wise to tap retirement accounts such as an IRA or a 401(k) to pay down debts. Generally my answer is no. Here’s why I say this, especially for those close to retirement.
Tapping tax-deferred accounts
If the money comes from an IRA, a 401(k), or a similar tax-deferred retirement account, you will owe income taxes on all the money withdrawn. If you withdraw $10,000 and are in the 25 percent income tax bracket, you will incur a tax liability of $2,500. If you absolutely need to net $10,000, you will need to withdraw $13,333 for example.
If you are younger than 59½, you will incur a tax penalty of 10 percent on top of any normal income tax liability for a distribution from a tax-deferred retirement account. That $10,000 withdrawal would now cost you $3,500. There are a few exceptions to this rule.
If you are 55 and have separated from your employer you may be eligible to take penalty-free distributions from your 401(k). There are also exceptions for situations such as death and disability. This chart contains a list of the exceptions to the 10% early withdrawal penalty for 401(k)s, IRAs, and other tax-deferred retirement accounts. Before moving forward with any of these exceptions it would be best to consult with a qualified tax or financial advisor.
Some 401(k) plans have a loan feature and if this is available to you this is likely your best route if you absolutely need to tap one of your retirement accounts. There will be a limit as to how much of your account balance can be borrowed and the number of outstanding loans you can have at one time. Also be aware that if you leave the company before fully paying back the loan the unpaid amount might turn into a taxable distribution.
You’ll be behind in your retirement savings
You might have good intentions and say to yourself that once the debts are paid off, you will have extra money with which to build up your retirement savings. Some folks will be able to do this, but most of us will find another use for the money. Further, if you’ve lost a job or seen your compensation reduced, this is even harder to do.
Moreover there have been numerous studies showing that many Americans are behind where they should be in term of their retirement savings. Some say that a general lack of retirement readiness is an epidemic in the U.S.
The most recent survey by the Employee Benefit Research Institute indicated that only 14% of the employees surveyed felt confident that they would have enough money to retire.
The most recent survey by the Transamerica Center for Retirement Studies indicated:
- Only 39% of the workers surveyed felt that they were building a sufficient nest egg to meet their retirement needs.
- 69% of those surveyed felt that they would not have accumulated enough in retirement savings by age 65 to meet their retirement needs.
Against this backdrop, in my opinion, using your 401(k) or other retirement savings to pay down debt should be done only after careful consideration and after all other alternatives are exhausted. You only have one shot at saving for retirement and this is a difficult enough task on its own. Tapping your retirement savings for other purposes creates a bigger mountain to scale.
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Bad idea. As you suggested, the 25% (marginal rate) young earner will have the 10% penalty in addition to the tax. $15,385 needs to be withdrawn to net $10,000. 30 years of lost growth, this money could potentially have grown to $120K or more (napkin math, 7% doubling every 10 years).
Instead, a $10,000 loan at 5% would be about $188/mo for a 5 year payoff. The payment on the same debt on a 24% credit card is $288. At the same time, I would argue with cutting the 401(k) deposit to just grab the match, and use the funds to save a bit of emergency money, so the next expense doesn’t just load the card up again. Other bloggers remind me it’s not only about numbers, it’s about motivation. I’m thinking a plan that doesn’t hack your retirement account, drops your interest burden by as much as 3/4, and puts you on track to clean up your debt in less than 5 years should fit the bill.
Joe thanks for the comment and your analysis. As always an excellent suggestion for folks to consider.
Good insight Roger. I would definitely tend to agree and think in general that it’s a bad idea. You can almost always find more ways to make some extra money to pay off debt, but retirement is a one shot deal. That 14% stat, though not surprising, is very problematic.
John thanks for your comment. Every retirement readiness study I read is sobering to say the least.
taxes….seems to be a stymier……if you do this…taxes…if you do that…taxes……taxes taxes taxes……getting oneself out of debt…stymied….the book of ways is small……very small
Thanks for your comment. When dealing with retirement plans, taxes for better or worse are a key consideration when contemplating an early withdrawal. This can make doing so prohibitively expensive in many cases.
Hi,
We are 65 years old and retired. $ 50,000 in cc debt. I have 65,000 in an Ira. My wife has 400,000. Pensions and ss equal 4600 per month. I really want to use my 65 to pay off the debt…..the stress relief alone would be a blessing….yes or no?
Carl thanks for your comment. While I can’t tell you definitively what to do, here are a few things to consider:
If you take the money from the IRA you will need to take out more than is needed to pay off the debt due to taxes. Additionally once the $50,000 is paid off the money is gone and also are you certain that you will be able to stay out of debt? Between your wife’s account and your pension and SS is this enough to fund your monthly expenses?
I can understand you desire to pay off this debt but I suggest you look at all aspects of this action before withdrawing the money from your IRA.
Hi there, is that true the collectors agencies, can withdraw the money out of your account?
Thanks Roger Wohlner
of course wen you retire?
Thanks for your comments Leonel. I have not heard this about collection agencies and that would surprise me.