Should you use your retirement savings to pay down (or off) debt?

If you’re carrying debt and also saving for retirement, you’re not alone: Over three-fourths of Americans have debt of some kind. And if you have debt, you might have also felt stuck: How do you take care of what you owe and also protect (and plan) for tomorrow?

It might be tempting to look at what you’ve saved in your retirement accounts and think, “How about using those funds to get out of debt now?” But before you take that step, it’s helpful to think through the tradeoffs and why using retirement savings to pay off debt may cost more than it helps.

Looking to your retirement savings to pay off debt may equal more short- and long-term costs than you realize. They include:

You may lose more money (through penalties and taxes) than you expect.

Withdrawing money early from a 401(k) or traditional IRA often triggers income taxes and a 10% penalty (if you’re under age 59½ and don’t meet exceptions). Say, for example, that you’re 45 years old and in the 22% income tax bracket. You have $20,000 in credit card debt you want to pay off, so you make a $20,000 early withdrawal. You won’t get $20,000, though; you’ll only receive approximately $13,600 by the time income taxes and a 10% penalty are deducted. You potentially will be still left with debt and less retirement savings.

You may give up long-term retirement savings growth.

Retirement savings grow over time through something called compounding. (That’s simply growth on both what you’re saving and earnings you previously accumulated.) If you withdraw retirement savings to pay off debt, you’re not only losing today’s balance; you’re losing future potential growth. And that’s a loss that can get harder to recover as you get closer to retirement and have less time to rebuild savings.

You risk creating a long-term problem with a short-term fix.

Some debt, like a mortgage, is long-term and probably planned for. But for other types of debt—overspending, emergencies (but no emergency fund) for example—withdrawing retirement savings to pay it off only serves to reset the cycle, not fix the problem. And in that case, the debt may come back, but the retirement savings may be gone for good.

For some people and in some narrow debt situations, a 401(k) loan—not a withdrawal—may be an option.

Here’s how a 401(k) loan works: You may borrow (not withdraw) from your retirement savings if available; the loan you’re making to yourself must be paid back, typically over five years. You do not incur penalties or taxes with a 401(k), and the interest on the loan also is returned to your retirement savings.

When does a 401(k) loan make sense as a way to pay off debt?

• You have very high‑interest debt like credit cards.
• You’re employed and don’t expect to change jobs before you pay off your loan.
• The 401(k) loan re-payments fit comfortably in your budget.
• You’re able to continue to make ongoing contributions to your retirement savings (at a minimum to get any employer match).

Even so, using a 401(k) loan to pay off debt carries real risks. For example, if you leave your job before you’ve paid back the loan, the remaining balance may be treated as a taxable withdrawal—with penalties. And while that money is borrowed and not sitting in your account, it’s also not invested, which may slow progress toward your retirement goals.

You may have alternatives that can help you pay off (or pay down) debt and preserve your retirement savings. Consider:

• Budget adjustments that help free up cash—even just a little at a time—to help increase your debt repayment
• Negotiations with creditors for lower interest rates or payment plans
• Debt repayment options such as balance transfers, debt consolidations, or nonprofit credit counseling 
• An emergency fund that you build (or rebuild) over time and in small amounts to help avoid future debt

Another plus these debt repayment options offer? They help you think through the real causes of debt, and, hopefully, adjust your spending and saving to avoid more future obligations. And, by learning what works for your life and budget to help pay off debt in the short-term, you can help protect your long-term retirement goals.