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Should I Pay My Debts With My Retirement Savings?

Should I Pay My Debts With My Retirement Savings?

Paying Debts With Retirement Funds

Many people face the tough decision of using their retirement savings to pay off debts. The average debt an American owes is $104,215 across mortgage loans, home equity lines of credit, auto loans, credit card debt, student loan debt, and other debts like personal loans. [1]

While paying off high-interest debt can offer immediate relief, tapping into retirement funds can have long-term consequences, such as penalties, taxes, and reduced savings for the future.

Deciding whether to repay debt with retirement savings is challenging, and carefully weighing the pros and cons is important. In this blog, we’ll explore the risks and benefits of using retirement savings for debt and consider alternative options for managing debt without jeopardizing your financial future.

The Pros and Cons of Paying Debts With Retirement Savings

When considering whether to use your retirement savings to pay off debt, weigh both the potential benefits and significant risks involved.

Pros

Cons

While paying off debt with retirement savings may seem like a solution, it’s critical to consider the long-term consequences that could jeopardize your future financial security.

The Pros and Cons of Paying Debts With Retirement Savings

Types of Debts to Consider

Not all debts are created equal, and the type of debt you’re facing can significantly impact whether using your retirement savings is a good idea. In this section, we’ll look at different types of debt and how each might influence your decision.

High-Interest Debt (e.g., Credit Cards)

Using retirement funds to pay off high-interest debt is a risky move that can harm your long-term financial security. While it may provide short-term relief, withdrawing from retirement accounts means losing out on future growth through compound interest, which could be more valuable than the immediate debt reduction.

Early withdrawals come with penalties and taxes, diminishing the available funds. By depleting retirement savings, you jeopardize your financial security in the future, especially when you no longer have a paycheck.

Low-Interest Debt (e.g., Mortgages or Student Loans)

For debts with lower interest rates, such as a mortgage or student loan, it might not make sense to deplete retirement funds. These debts are often easier to manage over time, and the interest you pay may be far less than what you could earn by keeping your money invested for retirement.

Medical or Emergency Debts

Unexpected medical expenses or other emergency debts can be overwhelming, and while using retirement savings might provide immediate relief, it’s important to consider the long-term impact. Tapping into retirement funds can solve an urgent need, but it also depletes your future financial security, reducing the potential growth of your savings.

Carefully assess all options, such as exploring payment plans, insurance coverage, or short-term loans, before draining your retirement account. While it may seem like a quick solution, using retirement funds should be a last resort to avoid jeopardizing your future financial well-being.

Medical or Emergency Debts

What Are the Tax Consequences and Penalties of Using Retirement Savings to Pay Off Debt?

Early withdrawals from retirement accounts like a 401(k) or IRA can trigger taxes and penalties. This means you could lose a portion of the withdrawn amount to taxes, reducing the overall benefit of using retirement funds to pay down debt.

Scenario

Let’s say you’re 45 years old, and you decide to withdraw $10,000 from your 401(k) to pay off some debt.

1. Early Withdrawal Penalty: Since you’re under 59½, you would face a 10% early withdrawal penalty. So, $10,000 * 10% = $1,000 penalty.

2. Income Taxes: The $10,000 you withdraw will also be treated as income and taxed at your ordinary income tax rate. For example, if your tax rate is 22%, you’d owe $10,000 * 22% = $2,200 in federal income taxes.

Total Impact

  • Penalty: $1,000
  • Taxes: $2,200
  • Total Deductions: $3,200

So, from the original $10,000 withdrawal, you would only receive $6,800 after the 10% penalty and income tax are deducted.

If you had waited until age 59½, you would not face the 10% penalty, but you would still owe regular income taxes on the withdrawn amount. This example demonstrates how early withdrawals can significantly reduce the benefit of using retirement funds, as you lose a portion of the money to taxes and penalties.

Exceptions

Although withdrawals from a 401(k) or traditional IRA before age 59½ typically incur a 10% penalty, exceptions exist where the penalty can be waived for “immediate and heavy financial need.” These include:

  • Medical expenses exceeding a percentage of your income
  • Costs for purchasing a principal residence
  • Tuition and educational expenses
  • Payments to prevent eviction or foreclosure
  • Burial or funeral expenses
  • Home repairs due to disaster damage

In these cases, the 10% penalty may be waived, though income taxes may still apply.

What Are the Tax Consequences and Penalties of Using Retirement Savings to Pay Off Debt?

Alternatives to Using Retirement Savings

Before dipping into your retirement savings, it’s worth exploring other options that could help you pay off debt without compromising your future financial security. Here are some alternatives to consider:

When It Might Make Sense to Use Retirement Savings

While withdrawing from retirement savings should generally be a last resort, there are situations where it may be a viable option.

If you’re overwhelmed by high-interest debt, such as credit cards, and can’t keep up with the growing payments, using retirement funds might offer immediate relief, as the interest on these debts can surpass the potential long-term growth of your savings.

If you’re nearing retirement and your debt is causing significant stress, tapping into your retirement funds to pay it off could help ease the transition and free up cash flow. Finally, if other options, like loan consolidation or refinancing, have been exhausted, using retirement savings may be necessary to avoid bankruptcy or further financial hardship.

When It Might Make Sense to Use Retirement Savings

If you are overwhelmed by debt, Richard West can help you understand your rights and guide you toward a solution that protects your retirement. Contact Richard West today.

Sources:

[1] Shelly Hoffman. (2022). Oregon State Risk Management Report. https://www.oregon.gov/das/Risk/Documents/Oregon_State_Risk_Management_Report_2022.pdf

[2] Boyte-White, C. (2024, June 4). How to Calculate Early Withdrawal Penalties on a 401(k) Account. Investopedia. https://www.investopedia.com/articles/personal-finance/082515/how-do-you-calculate-penalties-401k-early-withdrawal.asp

[3] Retirement plans FAQs regarding IRAs distributions (withdrawals) | Internal Revenue Service. (n.d.). https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-distributions-withdrawals

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