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Cashing Out Retirement Savings to Pay Off Debt

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.

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{ 17 comments… add one }

  • Ely February 12, 2010, 2:00 pm

    I would not recommend cashing out a retirement account to try 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 privelege. Not a good idea.
    I would also not cash out for medical bills or a refi, unless it’s one of those cases where you can avoid the penalty (there are a few). Instead I would borrow against the fund if possible. This way you avoid taxes and penalties, and pay interest back to yourself. It’s possible that you could find yourself unable to pay back the loan, and having to pay the taxes and penalties anyway, but at least you gave yourself a chance to avoid them.
    Also, you might mention that contributions to a Roth IRA (not earnings) are available to withdraw at any time, penalty free (they are already taxed).
    Just my .02, thanks. :)

  • Ben February 12, 2010, 4:28 pm

    Thanks for the suggestions Ely! I will incorporate your ideas into the article above!

  • Daddy Paul February 15, 2010, 12:04 am

    Cashing out a 401K or IRA should be a last resort. Just is importantly is investing it wisely.

  • Mathemetician October 5, 2010, 2:34 pm

    Seems like my savings account makes the same return as my old 401k and that won’t get me anywhere close to enough for retirement when i reach 59.5.

    I think it depends on if you look at the glass half full or half empty…how can you “lose” money you never really had to begin with? All your losing is your employer’s match ( which is a gimmic so they feel better about not providing a real retirement plan) and paying taxes on money you’d have been taxed on anyway if you kept it!

    After all, with Wall Street’s reputation…I dont have any faith that when i reach 59.5…their “assumed projections” on compounded interest will amount to squat.

  • Keith Douglas October 14, 2010, 10:21 pm

    With my faith in the economic system zero, and having lost half of what was in my 403b to the banks’ mismanagement, it makes sense to me to use the $ in my 403b to pay off my HELOC and credit card balances, which will still be due when the econ. tanks again. Secure my home. That is my current concern. The monies I would not be sending out will accumulate quickly and not ride the market fluctuations. Retirement saving after the death of the ‘pension’ is a gaff. I may take a hard hit now, but I assume the tax structures at time of retirement, which is not a likelihood anyway, will eat no less. Get out while there is still money left.

  • Mary December 30, 2010, 8:00 pm

    (I am reposting this, as in the post above I mistakenly put my email down for my website…if one must be deleted, please make it the above one. Thank you and Namaste!

    I am going to have to take out a significant portion of my 401k this year in order to take care of significant legal fees and credit card debt left from a rough year including a brutal betrayal by my business partner (the theft of my business), divorce, nervous breakdown and inability to work, being in school and establishing three new businesses in order to recover financially into the future. It will free up virtually all of my income, and eliminate all my debt, which is so important as I am now raising three boys on my own and am buying a home for us. I know it’s not the perfect scenario, but I feel I will benefit more from easing all this stress and quickly building up my savings again, then immediately embarking on an aggressive investment schedule to build my ira’s back up as fast and as much as possible. I will still have 130,000.00 in the IRA I am rolling the 401k into, and am almost done with my master’s degree and certifications (I am a personal trainer and yoga teacher) that will make me more marketable than ever. I’ve learned alot from this experience, including the value of health, gratitude and simplification…and not spending what you simply do not have. Now I am looking forward to moving from beyond gut-wrenching survival (and financial hemorrhage) to being able to take a deep breath, enjoy having a home again, and enjoying my babies and my renewed health. And no worries, I will never get into this kind of mess again. God bless you all.

  • CD April 27, 2011, 1:56 pm

    I’m going from one company to another, and the new company is a financial firm that has an AMAZING retirement system. My wife and I have our finances under control now, but are still paying for past mistakes made. For us, it makes sense to cash the retirement from the previous place of employment to have the lump sum and adjust our financial situation. I’ll make up the amount in less than 2 years with the new company. Sure, of course I’d be further ahead on the retirement account if I just transferred it over, but I’m young enough that I’ll still build up plenty of money for retirement. I’m happy retiring comfortable instead of rich.

    Looking online for different opinions on this, all anyone ever says is “DON’T DO IT!” Look, if you work in finances, and someone is asking serious questions about what the penalties are, how much it’d cost, etc., just answer them. Don’t be judgemental, and don’t just respond with “don’t do it!” It’s not helpful, and ultimately it makes those of us who need to uncomfortable with asking for advice.

  • Allison Radtke August 11, 2011, 4:46 pm

    I am in a similar situation as some of the people above. I have about $20,000 in a 403b account and around $10,000 in credit card debt. I have made mistakes in the past as far as credit is concerned and my rates are around 22% average. That means 2200 in interest per year. I am a single mom raising 2 kids. I’m cashing in, paying it off, and starting over! I work for the state and have a good retirement system in addition to my 403b from a previous job. I’m cashing it in before the stock market wipes it out!

  • Phil September 7, 2011, 10:15 am

    The comments above are quite helpful.

    I also thought about using retirement funds to wipe out all credit card debt and my second mortgage (all totaling about $80,000) and free up more income to put away.

    My situation:

    -Child grown
    -Have about $170,000 in retirement
    -Approx. $40,000 credit card debt
    -Turning 58
    -Have good paying job
    -Faced recent financial challenges (medical/family assistance) over last 5 months
    -Have 10 credit cards (3 with high balances, $15,000, $9,000 and $8,000)
    -Late payments only to the above 3 credit card accounts (3 mos, 2 mos, 1 month)
    -Made recent payments to 3 credit card accounts to bring accounts to temporary favorable status
    -Mortgage current
    -Completed graduate degree but left to pay last year out of pocket when reimbursement program was greatly reduced
    -Consulted with debt management counselor to go on budget and work with creditors to be paid out of a single monthly payment.
    -Waiting to hear from mortgage holder about modification or some other program
    -Want to reduce monthly expenses and increase savings

  • Bill March 8, 2012, 5:34 pm

    Wow… I find myself a bit comforted by the remarks above… Not that I’m stoked about that… I’m just happy that I’m not alone in the situations I face. Mary and Phil and Allison have echoed some of the sentiments I’ve been feeling lately. I’ve made some poor choices and I’ve gotten myself into a bit of a mess naively pursuing the “American Dream”… Keeping up with the Jones’… aquiring crap! All of that was “fine” when the means were there (Well… not fine… but manageable), but after a divorce and downturn in work, facing the possible loss of my home (mortgage company not really eager to work with me on loan remodification)… I’m just about at my wits’ end. I’ve got a solid job… good insurance… and a good relationship with my ex… and we’re able to work together on finances and such… but there’s not an option of her contributing at all my direction… just working with me… So… At a time like this… I look to what appears to be one of my only assets I have left to start over. I took out a loan on my retirement when we divorced and paid off our mutual credit card debt. Now I’m left with Car Payments, Unsecured Loan payments, the likeliehood of not being able to keep my home… and with outgoing regular expenses… left with very little breathing room between paychecks and a lot of stress. I’ve got about $35,000.00 in debt total… If I were able to pay that off… my paychecks would likely provide me with some options I just don’t have right now. Simplification is good for me as well… I’m not looking to retire wealthy. I’m 42 years old and have good opportunities to augment my retirement plans if I can just breathe for a little bit… I’m trying real hard to look at both sides right now, and I understand… it’s a trade-off we’re talking about. I can certainly appreciate CD’s comments about how discouraging and embarrasing it can be to ask for advice if what you get in response is an exclaimed, “Are you crazy?!!!” reply… Not to say that’s what was said here in the article above… But I’m desperately working with what I think I have as a tool. Thanks for enduring my rant…

  • Deb March 8, 2012, 5:36 pm

    My husband is 32yr trade construction guy who union went from 1000 members down to 300. He has been unemployed since 2008. We were able to sustain ourselves for 11 months without help, still keeing our 800 credit score. But I could forsee a problem in paying our mtg moving forward. We did get accepted into the HAMP program ater a year of paperwork which helped. But the union changed their rules and after 2 yrs of incontinuaty (not working the min hours to gain pension credits) he had to cut his losses and retire at age 55. He lost 35% of his monthly pension pmts. If he would have waited until Dec, it would have been 65%. This is all we have to live on for incoming monthly income. So we pulled out his supplimental retirement to pay off our home so we knew no one could ever take that away from us. Prior to gaining approval into the HAMP program, our lives flip floped. We went from upper middle class to flat ass broke poor, but alll our bills were paid on time ease to struggling to make our monthly pmts. Then when his pension pmts started top arrive it became apprant that it was not enough to sustain ourselves. We took out his suuplimental and took the 47% hit but it gave my husban peace of mind that our home which is all we own could nt betaken from us. Bankruptcy is a non issue as we have no other debt than the our monthly utilities, ins, etc….
    I was told verbally that if a long term unemployed person, retired & pulled out their retirement to pay off their primary residence, we could possible get the 10% penatly back. Is this true and if so where can I find out for sure. THanks!

  • Deb March 8, 2012, 5:39 pm

    Additional to my post….my husband is not gaining work anywhere….why…no one is hiring a trade guy who used to make $49 per hour, WalMart wont even take him. I am doingthe best I can but oits not enough. Did we make the right move and can we get the 10% penatly back on next year’s return?

  • Jay March 18, 2012, 5:38 pm

    Hi,
    You mentioned state tax. What if you move out of the country and then withdraw? Will it be just the 10% penalty and the fed tax and NO STATE tax? Please let me know and thanks

  • Lotus Flower April 4, 2012, 1:22 pm

    Would appreciate some insight as to my situation here: Early-mid 20s, no debt or other liabilities currently beyond basic living expenses (living with family so no mortgage currently), excellent credit, six months living expenses saved in emergency reserves, low tax bracket and live in a state with no income tax, etc. Currently employed but am in the process of becoming a business owner/ professional investor. Interested in acquiring some cash-flowing assets before year’s end; my main hurdle till then is just waiting for the paychecks to add up to enough cash with which to acquire.

    I have a mutual fund invested through a traditional IRA with about $1300 in it (not from employer, started as a $1000 gift a couple years ago), but with the economy in the toilet and only a matter of time before the whole thing implodes, I am wondering if it wouldn’t be better to withdraw that money now with the 10% penalty and use it to acquire those income-produce assets a bit sooner than I otherwise would be able to? I’m not trying to time the markets per se but I figure it would make sense to cash it out now while the value has been consistently rising, rather than wait for it to start going down. Maybe I’m missing something but a 10% penalty + measly fed income tax on $1300 seems worthwhile for a longterm cash flow that will more than pay me back . . .

    Any thoughts?

  • ruth tibbs April 19, 2012, 8:39 pm

    how can i cash out my retirement fund for one lump sum i need the money?

  • Alan July 22, 2012, 4:58 pm

    Gratefully, I am not in the difficult situations discussed above but do wish everyone great success in overcoming them. Not wealty by a long shot, but my wife and I started retirement plans (through work 403b’s and IRA then IRA conversions) at about age 32. Yes…we sacrificed. We’re in our early 60’s now. I am retired, my wife doesn’t want to yet but may in a couple of years. We are comfortable, have to be “careful”, but we’re OK and debt free. Many a time in our retirement savings years, we have wanted to pay off a mortgage, or buy a new car (conservative and cash), or other “temptations” with retirement assets but never did. SO GLAD NOW!!! HOW MANY TIMES CAN I SAY THAT!!!!! Best decision we ever made was to start “early”, not quit in the retirement savings plan and work with a recommended ACCREDITED financial planner.
    Anyway, my point is, in all the letters on this topic there is not 1TOTALLY CLEAR CUT reason (or excuse) to cash in retirement assets, pay the 10% penalty (under 59 1/2 years old) ,the federal and state tax, pay broker fees if applicable AND LOSE the long term growth potential for the funds for 10…20…30 years!!! To all those who are looking to take the easy and quick way out..and I have been tempted…do NOT do it!! I believe that in cases of extreme emergency there are federal provisions allowing withdrawl of retirement funds…but please check on this. If you are pondering using retirement assets to clean up messes that you can clean up over time….THINK TWICE! The minute you sign the papers, you are losing maybe a quarter, a third or more of what you have worked so hard to put into that retirement account.
    A friend is currently pondering the wisdom of withdrawing his 403b, which my MY rough estimate (he is over 59 1/2) will cost him about 25% of what he has put away. His reasoning, “I want a buffer in the bank”. Well, the 403b IS a buffer that he CAN withdraw from in a crisis. He is not in a crisis…just feels the need to rally the troops for retirement. DUMB MOVE….but I can’t convince him. In 10 years he may have, if he is LUCKY, somewhat less than the amount he will withdraw from the 403b… in some puny interest bank savings account…probably less…and no retirement assets. Plus…no benefit of the years of growth if the money were conservatively invested in the 403b.
    If it’s a crisis…there may not be a choice. If not…and you’re hanging on..DO NOT cash in retirement assets. It is a mistake you WILL regret when retirement approaches.

  • K November 7, 2012, 10:56 pm

    My husband and I are considering closing out one of my smaller retirement accounts. Layoffs, unemployment and the economy are killing us. WE both employed now, but we still don’t seem to be able to catch up, much less get ahead. The credit cards are out of hand – just paying bills and barely enough money for basic essentials, food, etc. We’ve cut back dramatically, but the situation continues to spiral downwards. I don’t want to cash in on a retirement account. I don’t need to live “rich.” I just want the stress to go away. We’re in our mid-50s, relatively close to retirement. When you have to put out more than what you take in, what else can you do? We wanted to refinance, but the current real estate market sucks and the value of our house dropped dramatically, so refinancing is no longer an option to help get one of our biggest bills down. We’re at such a loss, I don’t think we have any choice. Easy for some to say don’t do it, but the only other choice may be bankruptcy.

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