Many experts advise you not to touch retirement accounts until your golden years, but some high-interest debts can present a more pressing issue. Debt can cause your financial circumstances to deteriorate at an alarming rate, and resolving the issue can be the most advantageous move in the long run. Your retirement savings should probably be a last resort to meet your financial needs, for most people. You could incur penalties and taxes to use your retirement savings to pay off debt. Plus, you’ll lose out on investment income, which can be impossible to recover in the future. To help you determine if it makes sense for you to borrow from your retirement account to pay down debt, consider working with a financial advisor.
When It Makes Sense to Use Retirement Savings to Pay Off Debt
Generally, it’s best to leave your retirement savings untouched because you want as much uninhibited growth as possible. That said, paying off debt with your retirement savings in specific situations can make sense.
Various circumstances allow you to withdraw money from a 401(k) or individual retirement account (IRA) before age 59.5 without getting hit with the 10% early withdrawal fee. For example, if your unreimbursed medical debt is 10% or more of your adjusted gross income, you can withdraw from your retirement account penalty-free to repay the debt.
In addition, if you’re in debt to the IRS, you won’t have an early withdrawal penalty when you use retirement funds to pay. Similarly, you’ll avoid the penalty if you’re permanently disabled. Lastly, if you leave your job at age 55 or older, you can withdraw money before age 59.5 without penalty.
In situations where you can avoid the early withdrawal penalty, a chief consideration is the returns your retirement account generates versus your debt’s interest rate. For example, say you have $75,000 in your retirement account with an average annualized return of 5%. You also have $50,000 of debt with a 15% interest rate. In this scenario, your debt will accumulate quicker than your retirement account. So, paying off your debt with retirement savings will save you money in the long run.
You can also take out a loan from your 401(k) if you’re currently working. The loan has a host of benefits, including no taxes or penalties for money withdrawn. This option is advantageous if the 401(k) loan provides a lower interest rate than the debt. As a bonus, when you repay your loan with interest, all the money goes back into your retirement account – so you’re getting rid of debt and paying yourself.
Key Considerations When Using Retirement Savings to Pay Off Debt
Using retirement savings to pay off debt can help you reestablish financial stability. If you’re considering doing so, keep the following factors in mind to ensure you’re making a wise move.
Taxation on Withdrawals
Your retirement withdrawals will incur income taxes unless they are from a Roth IRA or Roth 401(k) account. The IRS will tax your withdrawal between 10% and 37%, depending on your income tax bracket. As a result, it’s necessary to calculate your estimated tax beforehand to ensure you withdraw enough to pay your debt. Again, the exception is a Roth retirement account, where you can withdraw contributions and earnings without paying income taxes.
Early Withdrawal Penalties
Early withdrawals create steep financial drawbacks. Typically, the IRS imposes an income tax on early withdrawals. Plus, unless you fit an exceptional circumstance like those listed above, you’ll pay an additional 10% penalty for withdrawing money before age 59.5. Therefore, if your tax bracket is 22%, an early withdrawal means forfeiting 32% of the funds you take.
So, if you need to repay $10,000 of debt, you’ll have to take about $14,500 from your retirement account. Remember, you won’t pay income taxes on early withdrawals on Roth accounts, but the 10% penalty will apply.
Future Retirement Savings
Although saving for retirement is crucial, about 55% of Americans are behind on saving for retirement. Unfortunately, withdrawing money ahead of time only compounds the problem. The less money in your retirement account, the smaller your returns will be. Of course, you can catch up by making future contributions when your financial situation is more stable. This feat is achievable later in life because your income in your 40s and 50s is usually higher than in your 20s.
That said, making up for years of missed wealth accumulation can be challenging. A more moderate option is to stop making retirement contributions and divert that money toward your debt. While you won’t put more money in your retirement account, you’ll leave the existing funds intact to continue earning returns.
How and When to Pay Off Debt and Save for Retirement
Your ability to pay off debt and save for retirement will depend on your financial circumstances. Doing both in tandem requires thoroughly examining of your finances and a solid financial strategy. Remember the following when creating your savings and debt repayment plans.
1. Weigh Debts Against Investments
Not every debt demands immediate repayment. For instance, mortgages are generally low-interest loans you pay gradually. As your equity grows, your home becomes an asset instead of a liability. On the other hand, credit card debt usually has astronomical interest rates that can ruin your finances quickly.
Therefore, repaying a credit card debt of $5,000 is immensely beneficial, whereas allocating an extra $5,000 toward your mortgage may not be as advantageous.
2. Take Advantage of Matching Contributions
Unless your debt situation is dire – say, you have a 20% interest rate or you must pay a debt in full – investing money in your 401(k) to maximize your employer match should likely be a top priority. Receiving free money (typically between 2% and 6% of your salary) in your investment account will accelerate growth.
3. Attack Your Debt Strategically
A mountain of debt can be so intimidating that you can’t see a path out. However, by taking a step back and evaluating your situation, you can create possible solutions for reducing your debt. For example, you might want to repay the lowest balance first. This approach lets you quickly experience the satisfaction of knocking one of your outstanding balances off the list, giving you a sense of momentum. You could also consolidate your debt and obtain a more affordable interest rate.
On the other hand, you can focus on the balance with the highest interest rate, saving you money in the long haul. In either case, it’s critical to develop a plan for your debt and stick to it. Random payments toward balances that seem urgent won’t help you as much as a strategy that gives you confidence.
The Bottom Line
Repaying debt is vital to your financial health. Although using retirement funds to address debt isn’t ideal, it can be viable. If you can avoid early withdrawal penalties or avert a steep interest rate from accumulating debt, your retirement account could bring financial relief and put you on solid footing. Plus, you can focus on rebuilding your retirement account once your debt is out of the way. However, it’s recommended to consider your options carefully: giving up investment perks such as 401(k) matching contributions can be worse than taking additional time to pay off debt.
Tips on Using Retirement Savings to Pay Off Debt
The need to grow your retirement savings and satisfy debt obligations can create a financial puzzle. Interest rates, matching contributions and unique circumstances all come into play. Fortunately, a financial advisor can bring clarity and help you use your money optimally. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Debt can be the biggest obstacle to building wealth. So, becoming debt free can help you accomplish your goals, such as buying a house, retiring or going to college.
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