Pros and Cons of Using Retirement Accounts to Pay Off Debt
Accruing large sums of debt over the years and facing years of high-interest payments is discouraging in the best circumstances. If you earn enough to make the minimum payments, do you really want to hold 15 plus interest debt for 30 plus years? Payments each month, barely move the balance, long after you stop using the card. Impatience leads to a search for creative solutions.
One solution to reduce debt faster is to use existing retirement funds. Retirement accounts can include, IRAs, 401K, 403b, and 457 plans that will give you the opportunity to save for retirement, through tax-advantaged accounts. However, using retirement balances to pay off debt, may eliminate tax benefits and result in less available for retirement needs.
Borrowing Against Retirement Funds Versus a Withdrawal
While IRA’s do not allow loans, many work retirement accounts such as 401Ks do offer loans against existing balances. Instead of withdrawing money from your retirement account, a loan gives you use of the money and time to pay it back without paying taxes on the funds. There are, however, risks involved with using retirement fund to reduce debt balances.
If you choose to access retirement savings, there are several benefits of utilizing a loan as opposed to withdrawals. Here are a few of the key reasons:
- You may have to pay penalties and additional taxes if you take a withdrawal before you are 59 1/2.
- When you repay the loan, the payment does not count towards the maximum contribution for the year, but a return on borrowed funds.
- There are no etax consequences if you follow the IRS rules regarding borrowed money. There are restrictions on how much you borrow and how long you have to repay. If you fall outside these guidelines taxes and penalties may apply to any remaining balances.
Pros to Paying Your Debt Down with Retirement Accounts
Save Interest. 401K loans typically have lower interest rates than bank loans, saving money on the repayment. Since you are paying yourself interest, you also limit the rate of return on the borrowed money during the repayment period. Those funds are no longer available for alternative investments at a higher rate of return. You are, however, eliminating much higher interest rate debt at a low cost of borrowing.
Increase Contributions. Debt reduction can free up cash flow to increase retirement contributions and pay the debt off faster than you could accomplish by paying the high credit card interest for many years to come. This strategy only works if you channel all your savings into paying off the loan and rebuilding your retirement account through an automated process. Failure to take this step can lead to higher levels of spending and new debt, rather than capitalizing on the savings.
Roth IRA Withdrawals. While IRA’s do not offer loans, regardless of your age, you may access the principal (the amount you contributed) to a Roth account as long as it has been in the account for five years. This action permanently reduces balances, and any new contributions are subject to annual limits. However, you avoid the repayment requirement along with taxation and penalties as long as you only withdraw actual contributions and not earnings. Taking earnings out of the account before 59 ½ could cost you the tax-free benefits along with a 10% penalty.
Cons To Paying Your Debt Down With Retirement Accounts
Taxable Income. Withdrawals from a 401K or traditional IRA result in taxes paid as ordinary income in the year of the withdrawal. Taking a large amount to eliminate debt can result in heavy taxation at higher levels, reducing the amount of cash you have to pay down debt. A loan is not treated as a withdrawal, although it reduces the money available to grow in the account while a loan balance remains.
Difficulty Replacing Funds. Most people are behind in saving for retirement and using funds from retirement accounts for either a loan or withdrawal, depletes those balances even further. The longer you take to set aside money in retirement the less time it has to grow. The result in more dollars required to build an adequate amount in retirement. Removing retirement funds should always be a last resort because you cannot borrow your way through retirement. Funds taken from retirement accounts are difficult to replace.
Protection From Creditors. Collection laws protect retirement accounts from creditors and typically owners retain the account even if debt negotiation or bankruptcy follow. Moving funds away from this protection gives creditors claims against the money in company retirement accounts and pension plans. There are two exemptions; creditors may access some funds in personal IRAs and pension or retirement funds paid to you as income may be subject to creditor payments.
No Opportunity to Change Spending Habits. Debt accumulated due to poor money management require more than a quick payoff. They also require a careful look at how you prioritize spending. Without addressing the cause, you could potentially lose retirement funds and still end up with debt problems down the road, which could eleave you struggling in your retirement years.
Eliminate ecompound interest while the loan balance remains. You could lose up to five years in compound interest by using funds to pay down debt, reducing the ability of the account to grow adequately for retirement needs.
Job Change. Any change in employment requires full repayment of the loan between 60 and 90 days from your last day on the job. Any remaining balance is deemed as a withdrawal, resulting in potential taxes and penalties. A job change could be voluntary or involuntary with the same results. eA loan is only a better option if you plan to continue working and plan to stay at your place of employment until the loan is fully paid off. Typically, the maximum repayment is five years, unless the funds are used to purchase a home.
Double Taxation. 104K contributions use pre-tax dollars, but repayment uses after-tax dollars, leading to taxed funds in the account. When you withdraw the funds at retirement, they will be taxed again as ordinary income.
Decreasing The Long Term Effects Of Borrowing From Retirement Accounts
Replace the loan balance as quickly as possible. Consider taking the amount you currently pay in debt and contribute the full amount to paying back the loan, to minimize the long-term effects.
There are multiple options to eliminate debt and tapping retirement funds may not be the best one. Reviewing your credit and potential long term consequences will help you decide if that is the right decision. Use caution with any solution that depletes savings for debt reduction, which can be difficult to replace.