This can seem like a tempting quick fix. Let’s face it. Paying off debt is hard. It takes discipline and sacrifice. If I have enough sitting there in my retirement account, it would seem like this would be an easy solution.
But, is this a good idea? Unless you are facing an imminent bankruptcy or foreclosure and you have no other opportunity to pay your debt, the answer to that question is no. There are several reasons for this.
Taxes and penalties
First, if you are younger than age 59 1/2, then the IRS will charge you with a 10% penalty for making an early withdrawal from your retirement account. On top of that, if your retirement account is a traditional IRA or 401K, you will also have to pay income taxes on the money you withdraw. Supposing you are in the 25% tax bracket, between penalties and taxes you would lose 35% of your money.
So, for example, let’s say our friend Bill had $20,000 in credit card debt. He’d actually have to take out $27,000 from his retirement accounts just to have enough left to pay off his credit cards. It’s kind of like asking “is it a good idea to borrow money at 35% interest to pay off his debt?” Effectively it is the same thing.
Finally, there is one more potential negative tax consequence. Remember the IRS considers these withdrawals income. Depending on how much debt Bill needs to pay off, it is very possible that “extra income” might push him into a much higher tax bracket.
The bottom line is using a retirement account to pay off debt is a very expensive way to accomplish your goal.
Lose future gains
In addition to the immediate cost of fees and taxes, there is also a long-term cost to using retirement savings to pay off debt. By pulling this money out, you will lose all future growth.
Let’s say our friend Bill was 35 years old. He pulls out $27,000 to pay off that debt. In 30 years when he is 65, even at a very conservative 8% rate of return, that $27,000 could have grown to $271,691! So between taxes, penalties and investment gains that he never saw, that $20,000 would have cost nearly $300,000 to pay off.
Don’t change habits
In many ways, this is the biggest problem. The important question is how did he get the $20,000 in credit card debt? The most likely answer is not some major purchase. Bill probably has no idea where that $20,000 went. It was a few dollars here and a few there. It really was a pattern of consistently spending more than he made. Little by little the debt grew and Bill didn’t even remember what he bought.
That habit of spending more than he made is the real root issue. Bill can take the easy way out and pay the debt off quickly, but if he doesn’t change his habits, in a few years he’ll be right back in the same boat, except there will be no retirement account to bail him out this time.
You can not spend more than you make on a consistent basis. Eventually, it will always catch up to you.
A loan is not the answer
There is another possibility that you may be thinking about. Instead of taking an early withdrawal, many workplace retirement accounts have a provision that allows you to borrow from the account and then pay your loan back to yourself over time through payroll deductions. Better to be paying myself back as opposed to paying a bank, right? That was the logic I once used, but I was very wrong. Loans against your workplace retirement account are not just a bad idea; they are dangerous.
First, the interest you are paying yourself is almost certainly less than the return you would be getting from a good mutual fund. But that’s not the dangerous part.
The big problem is if you were to leave your company, that loan becomes due in full within 60 days or the IRS considers it an early withdrawal and slaps you with the penalties and taxes we discussed earlier. A few weeks after you’ve just been laid off is a lousy time to suddenly find yourself owing several thousand dollars to the IRS.
The alternative to cashing out your retirement account
There are no short cuts. The only real path to financial wellness is to simply roll up your sleeves and start to attack that debt.
Live on a budget. You have to have a plan. Without a plan, money will always slip through your fingers like grains of sand. A real written budget will help you learn to live on less than you make. The budget will help you decide each month how you want to spend the money you have coming in.
Second, you need a plan for paying off debt. The best way I have found is to simply follow the debt snowball. List those debts smallest to largest. Squeeze every dollar you can out of that budget and attack the smallest one with everything you got. Each debt you pay off will allow you to put even more against the next one. The more you sacrifice for a short time, the quicker you will get out of debt and be able to enjoy the life you want.
And you can pay off that debt without sacrificing a comfortable retirement!