Retirement accounts, like a 401(k) and IRA, are a practice in delayed gratification. Millions of people have chosen to set aside money that they don’t need now in order to enjoy it later on in life. It’s an admirable goal that has many benefits. Life happens though. What if you are faced with a situation NOW, that requires more money than you seem to have? Does it make sense to pull money from an area where it’s not being used to help in an area where it will be used? First let’s take a quick look at what these 2 retirement funds offer and how they are different.
401(k) (Employer- sponsored retirement plan)
- Funded with Pre-tax dollars from your paycheck
- Tax-deferred growth on your investments
- Investment options provided by employer
- Matching payment plans often provided by employer
- Typically accessed after retirement to lower amount of taxes due (Roth 401(k) – Funded with after-tax dollars up to the plan’s contribution limit.)
IRA (Individual Retirement Account)
- Funded with dollars that can be classified as tax-deductible
- Tax-deferred growth on your investments
- Investing options are chosen personally
- Some matching payment plans available
- Typically accessed after retirement to lower amount of taxes due (Roth IRA – Allows a person to set aside after-tax dollars up to a specified amount each year.)
So why would you want to take money out of your 401(k) or your IRA to pay off debt? Let’s say you owe $20,000 in credit card debt. You look at your account and find a current balance of $30,000. In your head, it makes sense to take $20,000 out of your retirement plan and immediately pay off your debt. The money seems accessible and the plan looks straightforward and quick, but it’s not. Let’s take a look at what will actually happen.
How it Works
Here’s the way this scenario generally plays out with a 401(k) or IRA account: In order to access any money from your retirement plan, you must be 59-1/2 years old or there is an early withdrawal penalty. If you want to make an early withdrawal of $20,000, you will be penalized $2,000. You will also be taxed depending on the tax bracket in which your income level places you. Let’s say you currently make $60,000/year. You will have to pay 22% in income tax when you withdraw your $20,000. (A net income level of $80,000/year places you in the 22% income tax bracket) This means that you will be paying $6,800 (32%) of the $20,000 you withdraw which leaves you with a mere $13,200 to throw at your debt. There are some exemptions where a 10% fee can be waived but generally, you will still end up paying at least 12% in income tax no matter how much money you withdraw early.
So, does this approach make sense? What are the Pros and Cons of accessing your 401(k) or IRA to pay down debt? Here is a look at the good and the bad of pulling these funds:
- Quick access to available funds
- Balance may be replaced quickly if the fund has an employer -sponsored matching payment plan.
- Early withdrawal almost always includes a 10% fee
- Income tax adds 12% – 37% fee (see tax brackets )
- Amount of funds gaining compounding interest is reduced
While there are pros and cons to using this method, the disadvantages are too great to recommend it in most situations. So, how do you get a jump on your debt if you can’t make use of your retirement savings? Here are a few better options to consider.
Alternatives for Paying Down Debt
1. Buckle Down and Do a Budget
It would be more efficient to stop putting money into your retirement fund for 1 year and focus that money on debt, rather than withdrawing money early and paying the penalty. You’ll come out ahead if you do the hard work of creating a creating a budget, and start throwing as many available dollars as possible at your debt. It’s not glamorous, but it gets the job done.
2. Rob your Roth IRA
If you have a Roth IRA that you have been funding for more than 5 years, you should be able to withdraw tax-free funds from that account without penalties. (You’ll only be able to withdraw the principle – not any gains made on your investments) This will slow down your retirement savings, but if it cleans up some credit card loans, it should be worth it.
3. Borrow from tomorrow
Another possibility is to take out a loan from your 401(k) account at a low interest rate, and use the amount to immediately pay off a debt with a higher interest rate. As you are essentially using your own funds to refinance a loan, you’ll miss the opportunity to generate interest revenue on the withdrawn amount. However, this option might be just the solution for your debt situation. To find a more thorough description of this option, read this article: Paying Interest on a 401k Loan
4. Last Ditch Effort
If you’re up against a pile of debt and are in danger of having to declare bankruptcy or foreclose on your house, then taking funds from your 401(k) or IRA might be your only chance. However, getting professional advice in the area of Debt Management or Debt Settlement might help you save thousands. You can find more information by reading these articles: Options for Resolving Debt
The Ultimate Solution
In any and all of these options, the important factor is whether or not you choose to establish good money habits. A lasting change in finances comes down to a change in mindset. Determine to quit debt and develop a plan to make it happen. Going through the effort to pay down debt is only worth it if you learn from your past. Purpose not to repeat financial mistakes and you’ll be well on your way to a brighter financial future.