Editorial Policy

Why it’s not smart to tap retirement funds to pay debt

Allie Johnson

June 18, 2015

One day, you’ll need your retirement nest egg to buy clothes, groceries and medicine — so don’t use it to pay off your credit card today.

Most personal finance experts say it’s shortsighted to tap into your retirement account to pay off debt, but many Americans do it anyway.

In fact, a 2015 survey by investment management firm T. Rowe Price shows that 58 percent of Americans have taken money out of a retirement account to pay for something else — most often debt. About 20 percent of consumers said they’ve used retirement funds to pay creditors.

“People think, ‘Oh, retirement is down the road,'” says Kimberly Howard, certified financial planner with KJH Financial Services. “They think, ‘I’ll save more later. I want to take care of this debt now.'”

Don’t dip into retirement to pay debt

So, why isn’t it smart to take money out of your retirement fund to pay off that big credit card balance or other debt? Here are three reasons:

1. If you’re too young, you’ll have to pay a 10 percent early withdrawal penalty, says Kelley Long, a CPA and a certified financial planner for Financial Finesse. Anyone under 59 ½ has to pay the penalty.

2. You’ll have to pay federal and state income taxes on the money you withdraw, Howard says. Depending on your tax bracket, and whether the withdrawal income bumps you into a higher one, you could lose a good chunk of your money, as much as 50 percent of the amount you take out. Keep in mind that your tax bracket will likely be higher while you work than when you retire — which means you will pay more in taxes now than if you wait to take out the money.

3. You might be delaying or hurting your chances of retirement, Long says. According to the T. Rowe Price survey, 49 percent of Americans don’t think they’ll ever be able to retire.

But you might be able to avoid some of those problems by taking a loan from your retirement account instead of just withdrawing money early, Long says.

By making a loan to yourself, you can sidestep the early withdrawal penalty. You pay your retirement account back over time, so you recoup the money you took out. And finally, you’re paying yourself interest, so you get a little extra added in, Long says.

However, that doesn’t mean taking a loan is the best solution. Prudential offers a chart of pros and cons of taking a loan from your retirement account. One downside: The interest you pay back might be less than the amount the money would have earned sitting in the account.

Also, if you take a loan from your 401(k) then leave your job, you might owe the entire amount you borrowed within 80 days, according to Prudential.

“Then you have to try to pay it back right away,” Howard says.

When to use retirement money to pay off debt

However, there are some situations when it might make sense to use retirement funds to pay debt, Long says.

If you’re old enough to avoid the early withdrawal penalty, and if the interest rate on your debt is higher than the percentage you would pay in taxes if you took money out of retirement, then it might be a good idea to use retirement funds to get rid of your debt.

For example, if you have a 22 percent credit card interest rate, and you’re in the 15 percent tax bracket, it might be worth your while if, after paying the debt, you still have plenty of retirement funds left over.

“That’s just straight-up math,” Long says.

Alternatives to using retirement to pay debt

If you’ve decided it’s a bad idea to borrow (or steal) from your future to pay off debt you’re carrying now, you have other options. Here are four:

Put less into retirement for now. See if simply reducing your contributions to your retirement account temporarily will free up enough funds to pay off your debt, says Long, who gets a lot of calls from employees considering using retirement funds for debt. “The first thing I ask is: ‘Are you still contributing to your 401(k)?'” she says. However, as soon as your debt is paid, resume your contributions immediately so you don’t become accustomed to the “extra” money in your paycheck.

Sign up for a debt management plan. If simply changing your budget won’t cut it, a nonprofit credit counseling agency should be able to put together a debt management plan for you. The upside: The agency might be able to negotiate lower interest rates with your creditors. The downside: Your accounts will be closed, so you won’t be able to use your card. The best way to find a qualified agency is through either the Financial Counseling Association of America or the National Foundation for Credit Counseling.

File for bankruptcy. If you’re deep in debt, bankruptcy might be a far better option than using your retirement funds to pay creditors, says Ed Boltz, president of the National Association of Consumer Bankruptcy Attorneys. One reason is that when you file bankruptcy, your creditors will not be able to get their hands on your retirement funds. By taking out money to pay creditors, you’re giving them money they wouldn’t otherwise have access to, he says. “Congress wants people to be able to have money to take care of themselves when they’re retired,” Boltz says. That said, many people don’t qualify for bankruptcy, so check in with an attorney or credit counselor to weigh your options. Also, factor in the costs of filing for bankruptcy, such as paying for an attorney.

Buckle down. Of course, the toughest solution may be the best — reassess your budget and cut back on spending. Also, consider increasing your cash flow, whether it’s hosting dogs in your house through Rover.com or selling unwanted items on eBay.

So, look carefully at all your other choices before tapping your retirement account. “That should be a last resort,” Howard says.