5 min read
Should you pay off debt with your retirement account?
Be sure to understand all the consequences that could come from using your retirement account savings to pay off debt.
The average American works about 34 hours a week,1 reads 12 books a year,2 spends five to six hours on screens per day—3and has debt. In fact, if you’re like most Americans, you have more than $90,000 that you owe on credit cards, mortgages, student loans, and more.4
On the flip side, though, if you’ve started saving for retirement, you may have made good progress. For example, the average working household ages 45–54 with a 401(k)/individual retirement account (IRA) has accumulated a balance of about $106,000.5
If you’re trying to get out 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, raiding your retirement savings to pay off debt may equal more short- and long-term costs than you realize. Here are some tradeoffs to consider.
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. What are the true costs (and how much will you really see) if you withdraw from a 401(k) to pay it off?
The takeaway? You’ll need to withdraw even more than you think to cover your debt and all the penalties and taxes.
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 ramp up your retirement savings rate to recover? You may be giving up substantial returns, year over year.”
You’ll have to adjust your budget if you take a 401(k) loan with retirement savings.
If you don’t have another option for your debt but are wary of withdrawing from your retirement savings, you may consider a 401(k) loan.
- Limitations: Up to 50% of savings or $50,000 (whichever is less), in a 12-month period. Some plans don’t allow 401(k) loans.
- Payback: Within five years and with interest, which goes into the 401(k); if you leave your job, you must pay back the loan first.
- Taxes and penalties: None if you meet the terms of the loan. If you don’t repay the loan, you’ll be charged taxes and penalties.
- Costs: You’ll miss out on possible account growth during your loan repayment period.
Caution is key, Poorman says: A 401(k) loan is just that—a loan—so you’ll be required to make monthly payments. “That will reduce your monthly income, so make sure it doesn’t put you in a worse situation for the immediate future,” he says.
Each month you have income that you can divvy up however you want—retirement, vacations, dinners out, and more. “It’s all about tradeoffs,” Poorman says.
Your money is a tool for you to balance those tradeoffs and achieve your goals. Fundamentals—a budget that aligns with your income and expenses—can help. And you may have debt repayment choices that help ease some of the pressure, Poorman says, including consolidation or negotiating with a creditor to figure out a reasonable repayment schedule.
“You want to review every other option first,” Poorman says. “Would you have to work longer to make up those funds you withdrew? Would you end up in a similar situation a few years from now?”
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment or tax advice. You should consult with appropriate counsel, financial professionals or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
Investment advisory products offered through Principal Advised Services, LLC. Principal Advised Services is a member of the Principal Financial Group®, Des Moines, IA 50392.