Using Retirement Funds to Pay Off Debt

You’ve probably been putting money into your retirement fund ever since you started earning a regular income. Maybe you’ve been doing it with direct deposits taken out of every paycheck. Maybe you’ve been good about dropping a little into your account whenever you have some extra cash on hand. Whatever way, you’ve been doing it, you know it’s your money.

You know it’s there for your future.

Trouble is, you know it’s there in the present, too, when you find yourself buried under an avalanche of high-interest credit card debt or when you’ve fallen behind on your car loan or your mortgage or you can’t make the payments on your student loans.

That retirement fund is there, and it’s singing out to you like a Siren from Greek mythology: Come hither! Use me!

Word to the wise: Try to be like Odysseus. Resist the temptation. Don’t crash your retirement savings on the rocks of an early withdrawal from your 401(k) or IRA unless it’s absolutely, positively, unequivocally necessary and you thoroughly understand what the impact will be on your nest egg. As we’ll see a little later, different kinds of funds have different rules with different impacts on early withdrawals.

“There are lots of moving parts where spending, debt, and retirement accounts intersect, but the constants are stress and unhappiness,” said Vince Emmer, a financial advisor at Forestis Financial Analytics, Inc. in Colorado. “Paying off debt with retirement money is a bad idea when two conditions meet. No. 1 is when the debt is the result from discretionary spending. No. 2 is when one’s net worth is not yet large enough to provide a comfortable, very safe retirement.”

Sound like you? Well, keep this in mind: You want your post-working world to be as perfect as possible, right? That perfect world comes with a debt-free retirement, or at least one in which paying off your debt is do-able. After all, isn’t that why you’ve been putting money into those accounts? Using retirement funds to pay off debt right now — withdrawing funds from your traditional 401(k) or IRA before you turn 59½ — comes with financial penalties and heavy tax implications that can take some of the shine off your golden years.

Yes, it might provide short-term relief from your here-and-now debt load. But you should be very careful about robbing the Peter of your retirement to pay the Paul of your debt.

Implications for Early Retirement Fund Withdrawals

Building a stockpile for your retirement requires smart saving and investing. The ‘smart’ part means making a top priority of a lifestyle free from financial stress during your post-working years, so it’s important to understand what’s at stake when you’re tempted to use some of your retirement funds before you actually retire.

For openers, don’t overlook the fact that the bucks you’ve been saving haven’t just been sitting idle in your retirement account. They’ve been invested and they’ve been gaining compound interest. As soon as you take money out of your retirement funds, those dollars immediately lose that earning power. Plus, you’ve reduced the amount in your retirement account that continues to earn interest. The result? You’ve put some unwanted distance between you and your worry-free life on the porch with a cat on your lap in a rocking chair next to a side table with a cold glass of iced tea.

OK, maybe that isn’t your perfect retirement. We’ve probably seen too many old movies. The long-range point is that it’s important to keep your eye on the goal of living your best life, whatever form that life takes, when you finally finish working.

There is a more tangible short-range point to make, too, about an early withdrawal. Consider these implications:

Implication No. 1: When you withdraw money from a traditional 401(k) account or an IRA before you turn 59½, the Internal Revenue Service considers it to be new income and thus subject to income tax. (In most cases of early withdrawals from a 401(k), the IRS requires a minimum withholding of 20%.) And state income tax might come into play, too, depending on where you live.

Implication No. 2: In addition to the hit from income tax on an early withdrawal from a traditional 401(k) or IRA, the government imposes a 10% penalty on the amount you take.

Say your income tax rate is 24%, which is the middle rate among the seven federal income tax brackets for 2023. If you take $10,000 out of your 401(k) or IRA to wipe out your current outstanding debts, that’s a tax hit of $2,400, reducing your available funds to $7,600. Subtract another $1,000 for the 10% penalty, and you’re down to $6,600.

Even at lower tax rates, the damage is significant. If you’re in the lowest 2023 bracket – 10% — the IRS will take a $1,000 tax chunk out of the $10,000 you withdraw. And the additional 10% penalty still applies.

“Unless you’re 59½ or older, the IRS will smack you with that 10% penalty, and you’ll pay full income tax on the withdrawal, the penalty and the tax,” said Emmer. “That’s right; there’s tax on the tax. Pretty good racket the IRS has going, isn’t it? So if you’re, say, in the 17% federal and state tax brackets, you’ll have to withdraw $13,699 to pay off $10,000 of debt. Taxes and penalty are $3,699. Not nice. But exciting for financial masochists.”

Bottom line: Don’t hurt yourself. Early withdrawals aren’t a smart way to save.

401(k) Rules and Penalties

A 401(k) is the account you have through your job. It’s an employer-sponsored fund into which you automatically direct a portion of your regular paycheck, and the company invests it for you in a selection of options. The value of keeping that account intact and robust is a pretty solid argument against using a 401(k) to pay off debt. The implications of closing and withdrawing from a 401(k) is another.

There is an annual limit on how much you can contribute to a 401(k); in 2023, it’s $22,500 if you’re under the age of 50. Many employers will match your contribution up to a certain amount. But however much you put into your 401(k) account, you haven’t paid taxes on it (or the interest it earns while it’s in the account) yet. That’s why you take the income tax hit when you withdraw funds from it.

You’ll pay the 10% penalty, too, for an early withdrawal. The penalty is waived after you reach the age of 59½, although there are some exceptions that allow you to withdraw retirement funds before then without incurring the 10% penalty. (We’ll get to those in a bit.) But you’ll be charged the income tax whenever you withdraw 401(k) funds, even after you’re 59½.

A 401(k) plan only distributes benefits to contributors under certain circumstances, which differs from the regulations governing an IRA (read on!). Although there are ways to roll a 401(k) into an IRA, you typically won’t be able to close your 401(k) out altogether while you’re still employed by the company sponsoring the plan. You could choose to stop making the payroll deductions for it, but you’d lose out on the pre-tax benefits and company matches.

One more thing. It’s worth the time and effort to research the specific 401(k) plan offered by your employer. It might include regulations and guidelines that are in addition to what the IRS mandates. An example: Some 401(k) plans allow you to take out a loan from your retirement account. Others don’t.

Traditional IRA Rules and Penalties

Unlike a 401(k) which is offered by an employer, you open your own IRA (Individual Retirement Account) independently at a bank or through a broker. The annual limit for IRA contributions ($6,500 if you’re under 50) is lower than for a 401(k), but an IRA generally offers more in the way of investment options.

As with a 401(k), you’ll pay income taxes and the 10% penalty for withdrawing IRA funds before you turn 59½ if you use the money to pay off most kinds of debt. But if you’re willing to shoulder those burdens, you can take a distribution from your IRA at any time simply by contacting the financial institution that manages the account.

One way to avoid the taxes and penalty is to transfer that money to another retirement account within 60 days after you take it out. That happens when, for example, you switch jobs and want to move your retirement funds to a plan managed by your new company. The IRS puts that kind of transaction in a category called a “nontaxable rollover.”

As with a 401(k), IRA plans include some other exceptions to the 10% early withdrawal penalty, too.

One other difference between an IRA and a 401(k): IRA plans do not offer loans.

Roth IRA Rules and Penalties

A Roth IRA works from the opposite end of the taxing process. Contributions to a Roth IRA are taxed at the time the money is put into the account. That means there are no additional income taxes if you want to withdraw what you’ve put into it, as long as you’ve owned your Roth IRA account for at least five years.

The key words in that last sentence are “what you’ve put into it.” Before you turn 59½, that’s all you can withdraw. You can’t get to any of the earnings (compound interest growth) the fund has accrued. If you do make a withdrawal before you’re 59½, you’ll pay a 10% penalty, but only on the earnings.

Exemptions for Early Withdrawal Penalties

We’ve mentioned that both 401(k) and IRA accounts will waive the early withdrawal penalties in some circumstances. In both kinds of retirement funds, you can get to some of your money penalty-free if you meet any of a number of requirements or intend to use it for a certain purpose.

Many of the exemptions come into play when they are considered to be hardship withdrawals, such as when you are disabled or are facing excessive medical bills. We should note, though, that none of these penalty-free withdrawal exceptions will be granted simply because you need to pay off credit card or loan debt.

These are reasons the IRS will waive the 10% penalty for an early withdrawal:

• If you have unreimbursed deductible medical expenses that are greater than 10% of your adjusted gross income. The withdrawal for this reason has to be made in the same year the medical expenses were incurred.
• If you have been totally and permanently disabled. (Your beneficiary is entitled to penalty-free withdrawals after you’ve died.)
• If you’ve been unemployed for at least 12 weeks and you use the withdrawal amount to pay health insurance premiums.
• If you owe unpaid taxes and the IRS places a levy against your retirement account.
• If you’ve been called to active duty as a member of the military.
• If you agree to a Substantially Equal Periodic Payment (SEPP), which means you must continue to take out a certain amount from your retirement fund at regular intervals over a set number of years. Note: You can use a SEPP for penalty-free 401(k) early withdrawals only if you are no longer employed by the company that sponsored the plan.

As we’ll see next, other exemptions apply either to a 401(k) or an IRA, but not to both.

401(k) Exceptions

The language in the 401(k) rules governing withdrawals for hardships allows money to be taken out penalty-free before you turn 59½ if you are facing “immediate and heavy financial need.” The rules are meant to provide relief for circumstances such as funeral expenses, overdue rent when eviction is imminent, or repairs to your home after a natural disaster. In other words, your high-interest credit card debt will be a tough hardship sell to the IRS. In any case, you are only allowed to take out the amount you need to cover the hardship expense without incurring the penalties.

Here are three other 401(k)-specific exceptions that allow early withdrawals without income tax or penalties:

• If you leave your job during the year you turn 55. (The age requirement is 50 for some federal and state jobs.)
• If you get divorced and the 401(k) is part of the divided assets in the settlement.
• If you’ve over-contributed to your 401(k)

IRA Exceptions

IRA rules allow for penalty-free early withdrawals in a handful of cases that 401(k) regulations don’t. Among them are:

• When you are using the money for qualified higher education expenses.
• When you are buying your first home.
• When you need the money for health insurance premiums during times that you aren’t employed.

Another way to avoid the tax and penalty in an early withdrawal from an IRA is to transfer the amount you withdraw into another retirement account within 60 days of the withdrawal.

Alternatives to Withdrawing Retirement Funds to Pay Off Debt

If you’ve read this far, you can probably tell we don’t recommend dipping into your 401(k) or IRA to get those pesky creditors off your back when there is a way to avoid it. There are ways around it, and we do recommend you explore them first before you heed the Siren’s song about an early withdrawal.

If the need for fast cash for debts is immediate and critical and you’ve determined that your 401(k) funds are the only available alternative, then you might want to find out if your company’s plan allows you to take out a loan from those savings.

If the need is less urgent and you have some time to work on a solution, then it might make sense to re-think and re-shape how you’ve been handling your money. With the right budget and organization in place, you could find a path to using your current earnings or another debt pay-off strategy rather than your retirement funds to get relief from your debts.

We’ll briefly examine those alternatives next.

401(k) Loan

Some plans will let you borrow from your own 401(k) kitty; others won’t. If yours does, it might make sense for you. You won’t pay the taxes and penalties associated with a conventional early withdrawal. Nor will your credit score be impacted if you miss a payment or even default on the loan. Why? Because you’d be defaulting on your own money.

“If you have no other consumer credit, a loan from your 401(k) might be a useful get-out-of-jail card,” said Forestis Financial’s Emmer. “You’ll pay interest, but it’s to yourself, so that’s easy. No penalty, no income tax as long as you pay on schedule. There is fine print, though, so make sure you understand that.”

With most 401(k) loans, you can borrow as much as 50% of your savings, up to $50,000, and you’ll have five years to pay it back. (That time frame becomes much shorter if you part ways with the employer who sponsors your plan.) But remember: The amount you borrow from your 401(k) isn’t accruing the investment and interest earnings it would gain if you left it in the account. And there’s a good chance the interest it would earn there could be more than the interest you’ll pay back to yourself on the loan.

Create a Budget

The basics of budgeting are simple. You list your expenses in one column and your income in another. Add up each column and compare the totals, and you’ll see whether you’re outspending your resources.  If you are, that’s a pretty good indicator of how you got yourself into the kind of debt that has you thinking about using your retirement funds to escape it. When you create a budget, it’s easy to make adjustments to one column or the other (or both) to bring your expenses in line with your income.

Here’s Emmer again on what a budget can do for you: “There’s no foolproof fix, but one big step is keeping track of your spending. If you’ve reached this stage, reviewing your balances or even every transaction every day is not too much. Living within one’s means is easy to define then. Pay all ordinary expenses, build or maintain cash reserves equal to six months of living expenses, build retirement savings, pay off existing debt in a short time frame without adding debt from other sources.”

In time, a budget will put you in control of your money. Which is where you want to be, right?

Use a Debt Pay-Off Strategy

Once you’ve got a handle on your income vs. your expenses, there are a couple of strategies you can use to address your debt without emptying out your 401(k) or IRA.

One is called the debt snowball method, in which you rank all your debts from smallest to largest, no matter what interest rates they carry. This method wants you to concentrate your efforts on paying off the smallest debts first while making minimum payments on the others. The theory is that by starting small, you’ll have an easier time making early headway in the debt reduction process. And with each debt you eliminate, you’ll gain momentum like a snowball rolling downhill.

Another is called the debt wrecking ball method, and it takes the opposite approach. Also called the debt avalanche approach, it has you ranking your debts by the interest rates you’re paying on them and then attacking the list from highest rate to lowest (again, keeping up with the minimum payments on the others, too.) If your ability to make the higher-interest payments allows it, the wrecking ball/avalanche method might be the preferred option in that you’ll make a faster and more significant impact (like a wrecking ball) on your debt load.

Opinions vary on the advantages and disadvantages of the snowball vs. wrecking ball method, but both methods use the ranking technique known as debt stacking.

Speak to a Credit Counselor About Your Debt

These aren’t easy decisions. On one hand, your creditors aren’t going away if you can’t pay off your debts, and the money to meet those obligations is right there in your retirement funds. On the other hand, the prospect of a worry-free retirement is why you’re working so hard right now to keep your IRA or 401(k) fully funded and robust.

What to do?

Here’s one valuable answer to that question: Ask for advice. Credit counseling can help you create a budget to pay off your debt and help you decide whether withdrawing funds from a retirement account to ease that burden is the best option. A counselor can steer you toward a solution that addresses today’s problem without making your situation worse tomorrow.

A nonprofit credit counseling agency will help you understand all of your options, including a debt management plan in which a counselor works with your creditors to reduce interest on your credit card debt and lower your monthly payments to a level you can handle without disturbing your IRA or 401(k). Counselors are trained and certified in the areas of budgeting, consumer credit, and money management, among other things.

Best of all, advice from a nonprofit credit counseling agency certified by the National Foundation for Credit Counseling (NFCC) is free of charge. You won’t need to make an early withdrawal to get the answers you need!