A Trees Full of Money subscriber writes in…
Is it a good idea to use money in your 403b retirement account to pay off your debts?
The Short Answer is NO!
In almost every situation where early withdrawal penalties apply (i.e. the individual is younger the 59 1/2, etc.), it doesn’t make financial sense to withdraw retirement savings from a Traditional IRA, 401k, or 403b to pay off your debt.
Watch Out for the Taxes!
When you make an early withdrawal from a Traditional IRA, 401k, or 403b, you are responsible to pay federal income taxes on the amount you take out (after all, the money was placed into your account tax free). For most of you reading this personal finance blog, this amounts to 15-28% in taxes depending where your income falls in the IRS Tax Schedules.
Additionally (depending on your state), you will also be responsible to pay state income taxes. If you live in Maine like me, that can easily be an additional 9%.
Finally, you will also be responsible to pay a 10% penalty fee (or excise tax) on the amount of money you withdraw from your retirement account.
Add this up, and you will end up paying 34-47% in taxes and penalties just to access your money!
Paying 34-47% in taxes and penalties so you can pay off a credit card at 18% interest is not a wise financial move!
Does It Ever Make Sense to Tap Retirement Accounts to Pay Off Debt?
I can think of very few situations where I might consider an early withdrawal from a 401k, 403b, or Traditional IRA to pay down debt.
Avoiding Bankruptcy: Previously, I mentioned that cashing out your retirement accounts might make sense to avoid foreclosure on your home, or personal bankruptcy. I would like to highlight a reader’s thoughtful comments on this idea:
I would not recommend cashing out a retirement account to avoid bankruptcy, unless you know for a fact it will work. Retirement accounts are protected from bankruptcy; if you have to file, you could lose everything and still hold on to those accounts. However, if you cash them out and still end up having to file, you are truly left with nothing, and you paid taxes and penalties for the privilege. Not a good idea! Ely
Refinancing Your Primary Residence: In a previous article I wrote about the idea of borrowing money from your 401k to cover negative equity when refinancing your home to a lower interest rate.
Interest rates are once again near historic lows. Unfortunately, many home owners lack the standard 10-20% equity required to refinance their homes as per the “new lending standards”.
If you have a mortgage balance of say $200,000 at 6.5% interest per year, you could save $3,000 in the second year alone if you could refinance at an interest rate of 5% (the first year’s savings will most likely be eaten up by your closing costs).
In situations like this, you need to look at the opportunity cost of not cashing in your retirement accounts. Even if you paid the 10% penalty, you very well may come out ahead from the overall savings in interest.
I still recommend that you find an alternative way to make the refinance happen before tapping your retirement accounts (working more overtime, getting a second job, sell off some of your big boy toys, etc).
Consider the Future Value of Your Account
Most importantly, you need to consider the future value of the money in your dormant retirement account(s).
Cashing out your 401k to pay off an old credit card balance may seem like a quick fix, but how much is that $20,000 balance going to be worth 10,15, or 30 years down the road? Do you have a plan to rebuild your retirement savings once you are debt free?
From my own personal experience, I regretted cashing out one of my wife’s old 401k accounts to purchasing furnishings for our newly constructed house. The furniture is already showing its age, and had we simply left the money alone we would thousands of dollars ahead of where we are now.
Whatever you decide, make sure you give careful consideration to all the financial ramifications and are not just treating the symptoms of an out of control financial lifestyle.