Normally, it might seem wise to pay off your debt before you save for retirement. In general, if you have high-interest credit card debt that is not tax deductible, paying it off before saving makes sense.
Many would suggest against draining your 401(k), IRA or other retirement assets to payoff credit card debts. This is simply because if you’re under 59½ years, you can face 10% penalty plus taxes on the withdrawal amount.
Still, sometimes cashing out your retirement funds to pay off debt seems to be a wise alternative. It’s when you have decades of work left, can borrow from an employer-sponsored retirement plan – and then paying back the loan to yourself without any tax consequences.
Let’s consider the major options .
Withdrawal from 401(k)
In a majority of cases, you can only withdraw elective-deferral contributions, the deposits that you asked your employer to deduct from your paycheck and contribute on your behalf to an employer-sponsored retirement plan. You cannot withdraw all the money that is deposited into your 401k account.
You just can’t withdraw the funds because you’ve accumulated huge debts since your employer contributed the money for the sole purpose of your retirement. However, the funds can be withdrawn for early retirement, in case you get laid off, or switch jobs.
Also, depending on the nature of the plan, you may not be able to withdraw at all or only in hardship situations such as for tuition or fees, crucial medical expenses, purchasing a home, prevent foreclosure, or emergency home repairs.Paying off debt might be considered as a hardship if it is allowed in your plan.
If you make early withdrawals from your retirement account, you’ll face some income tax adjustments plus a 10% penalty. For instance, if you take out $25,000 to pay off debt, it’s $22,500 that you’ll actually get. Again, since your 401(k) contributions were tax-free, you’ll now have to pay federal income taxes on this.
When cashing out your 401(k) makes sense
Sometimes, it’s beneficial to cash out a portion of your 401k) to pay off a debt with an interest rate of 18%-20%. For instance, if you have a credit card debt of $25k, and you just keep paying the monthly minimum of $415; it’ll take you about 13.2 years to pay off, and you’ll pay a whooping $40k in interest to the credit card company. Such a figure would compel you to try the alternatives you have got.
However, if you’re in the 25% tax bracket and have to pay 10% in penalty, you’ll have to withdraw $38461.11 from your 401(k) to pay off that $25k. Instead, if you keep that amount in your retirement account for 13.2 years and earn 8% on it, it’d be worth about $104,599.75.
So even after paying all the required taxes, you’d have earned more in your 401(k) than paying in interest on the debt.
Withdrawal from IRAs
Cashing out an IRA is a costly option to consider and also an unwise one due to a lot of factors. Rules vary – depending on your account type. However, if you withdraw funds early from an IRA, you’re likely going to face taxes and/or penalties, which substantially adds to the cost of taking out the money.
With a Traditional IRA, you have to pay income taxes on withdrawal since you didn’t anything upfront. In addition, if you’re making an early withdrawal (before the age of 59½), you’ll likely have to pay 10% as penalty.
On the other hand, a Roth IRA allows you to withdraw funds without any tax consequences, provided that the money has been there for at least five years since the contribution was made with after-tax money. However, the withdrawal is limited to the amount you’ve actually contributed. Anything beyond that is subject to taxes since it comes from investment earnings. Also, if it is taken out before 59½. All the early withdrawals are subject to 10% penalty.
Unfortunately,a significant early withdrawal from Traditional IRA could bump you into a higher tax bracket. Something similar could apply to earnings from a Roth IRA, which would be taxed and considered as income in the year in which it was withdrawn.
Indeed, you’re going to take a hit. So if you wish to proceed, chalk out a plan that ensures minimum collateral damage.
Alternative Methods to Reduce Debt
Apart from cashing out your retirement accounts, there are many other options to reduce debt and interest rate. Here are a few:
- Negotiate your interest rate with your credit card company. If you have good credit, they might be interested in reducing your rate by a few percentages
- Negotiate principal. If you have got huge figures and behind your payment for a couple of months, creditors are likely to forgive a part of the principal
- Make extra payments to reduce interest charged and loan length
- Get help from professional debt settlementand consolidation companies since they are qualified and have got proven track record
- Make use of balance transfer credit cards and roll on all your debt to a lower interest credit card
- Borrow from your 401(k) than cashing out.This is more effective since it will force you to replace the money you take out
So, what’s the bottom line ? It’s probably not a great idea to spend the money overnight you’ve accumulated over the years. With a 401(k) loan, you pay yourself back the money you borrow along with interest. The best part is that the loan immediately gives you relief from the high-interest credit card debt that exploits you financially.
Thank you so much to guest contributor Andy Masaki for the article “Should you Pay Credit Card Debt from Retirement Savings?” He is a 28-year-old freelance journalist living in Oakland. Andy works for Oak View Law group, a leading consumer and bankruptcy law firm based in CA and operational across US. Follow him on Twitter, Facebook or get in touch at : andymasaki(at)gmail(dot)com.