Can You Use a Pension to Pay Off Debt?
At a Glance
During an employee’s years of work, their employer may make regular contributions to a pool of funds set aside for the employee’s future. The funds are invested on the employee’s behalf, and the earnings help make the pool grow larger. These funds, called a pension, can then be withdrawn to support the person’s retirement.
As long as the person continues to meet eligibility criteria, they will receive a monthly payment from their pension, typically calculated with a formula taking into account their years of service, as well as their earnings.
Once you meet the eligibility requirements, the pension payments are yours to use for whatever you deem fit. However, if you’re considering withdrawing those retirement funds early to pay off debt, there are pros and cons to weigh before making a decision.
In this article, you’ll find information about:
Can I get a loan against my pension?
If you have a pension, you can get a loan against it. This is also called a pension advance, pension sale, or pension buyout.
You may consider getting a loan against your pension if you need more money than your retirement benefits pay each month. While loans for pensioners vary from one plan to another, you are ultimately tapping into your retirement savings to pay off a large, one-time bill or emergency/unexpected expense. The primary eligibility requirement is that you have money in your pension account, and you must be actively employed by the company sponsoring the pension plan. Eligibility can also be based on your years working for the company.
How much you can borrow depends on your account balance, and it’s likely a percentage along with a limit. For example, up to 50% with a limit of $50,000.
While this may seem like a good option if you need cash, it’s important to pay close attention to the payment terms, including:
- Interest rate
- Fees
- How often you’ll need to make payments
- How long the term is
Note that the longest repayment period the IRS allows is five years, so you’ll only have a maximum of five years to repay the entire loan plus interest (or you’ll be taxed). Also know that interest rates can be very high, as can fees you’ll be charged. In fact, the Consumer Financial Protection Bureau (CFPB) warns customers of taking loans against their pensions and encourages them to seek other alternatives.
Can I cash in my pension to pay off debt?
If you’re struggling from debt but approaching the age where you’ll be eligible for retirement funds, it may be tempting to use those to pay off your debt fast. You can use your pension to pay off debt if:
- Your age 55+
- You have a personal or company pension you’re not currently paying into or receiving
- You can, at any time in the future, be employed and be able to continue to work
You have the ability to cash in 100% of your pension as a lump sum, though only the first 25% is tax-free. The rest would be taxed at your marginal rate applicable at the time you take it.
However, just because you can use your pension to pay off debt doesn’t necessarily mean you should. In certain situations, contributing a lump sum to debt repayment may be more beneficial than not. But, when you take money from your pension to pay off debt, you’re leaving yourself a lower monthly income for the rest of your life.
Related: How to Pay Off Debt Fast
Types of pensions you can cash in to pay off debt
There are primarily three types of pensions that can be used to contribute toward debt repayment: contribution pensions, benefit schemes, and local government pension schemes (LGPS).
In general, pensions that do not apply to the “state old age pensions” can be used.
1. Contribution pensions
These defined pensions include company, personal, stakeholder, and group personal pensions. They are typically tax-deferred and the contribution is known.
2. Benefit schemes
Also defined, these are categorized under private sector and public sector funded salary pensions that are final. This benefit is a specifically defined multiple of certain predetermined variables, such as your average pre-retirement salary and years of service. The employer may opt for a fixed benefit or one calculated according to a particular formula.
3. Local government pension schemes
The LGPS is a tax-approved, defined benefit scheme for employees who worked in local government. The benefits are set out in law and adjusted in line with the cost of living each year for the rest of your life.
Options for using a pension to pay off debt
When it comes to using a pension to pay off debt, you have two main options: a lump sum or a pension contract.
- Lump sum: You can take out a 100% cash lump sum, which can be used toward your debt payments.
- Pension contract: You can transfer your pension fund to an approved pension contract, which puts you in control of the funds. Similar to a savings account, you can then access the funds and use them for whatever you like.
With either option, once you get the funds, you can use them to pay off your debts
If you pass away, you can transfer your pension to your heirs. If this happens before you turn 75, the death benefits are paid with no tax involved.
Using retirement to pay off debt
If you choose, you can pull from your retirement to pay off debt. However, it’s not always recommended.
Most experts suggest leaving retirement funds in the retirement account so that funds are there when you need them and are no longer making your working wages.
There are also situations where you could incur fees or other penalties by withdrawing from your account. For example, you’ll be penalized if you withdraw 401(k) funds before age 59 ½. If you withdraw earnings from a Roth or traditional IRA, you may also have to pay penalties and taxes.
While in some cases you can pull from retirement to pay off debt, there are also instances where you could use a loan for debt repayment. If you’re considering using a loan from your retirement funds to pay off debt, your options are a 401(k) loan or pension loan.
Related: Is it Good to Pay Off Debt or Save?
Using a 401(k) loan to pay off debt
If you need funds to repay debt and don’t have other resources available, you may want to use a 401(k) loan, which would let you borrow money from your retirement savings and pay it back (to yourself) over time. While you would have to pay interest on the loan, both the loan payments and interest would go back into your account.
Depending on your plan, you may be able to take up to 50% of your savings, or up to $50,000 in a 12-month period.
However, keep in mind that in most cases you’d have to repay the borrowed money and interest within five years of taking out your loan. There may also be restrictions on how many loans you can have outstanding from your plan.
Unlike a straight withdrawal, you will not pay taxes or early withdrawal penalties on a 401(k) loan. Plus, since the interest you pay goes back into your retirement plan account, you’ll be growing your account, though, you’ll miss out on the growth from having that money invested. Another benefit is that if you miss a payment, it won’t impact your credit score.
On the other hand, if you take out a 401(k) loan while still working and then leave the job, you may have to repay the loan in full in a short period of time. And, if you can’t repay the loan and default, you’ll owe both taxes and a 10% penalty if you’re under age 59 ½.
Related: Should You Borrow From 401k Loan To Pay Off Debt
Using a pension loan to pay off credit cards
If you don’t want to completely withdraw your pension, you may opt to use a pension loan, also known as a pension advance, pension sale, or pension buyout. Unregulated in the U.S., this support comes in the form of a loan paid in regular installments for a short or indefinite period of time, or as a lump sum.
Because they are unregulated, it’s not typically recommended to use a pension loan. Interest rates can be very high, you may be charged fees, and you could also find yourself in a higher tax bracket if the payment comes in a lump sum.
If your state does offer pension loans, there are usually specific criteria you must meet such as being an active member of the retirement system, having worked a certain amount of time, and having an application approved.
A pension loan typically does not affect your credit score because it is not reported to credit bureaus. However, if you default on the loan, it could have serious consequences, such as penalties, taxes, and potential legal action, which could eventually impact your credit score. Don’t let your credit score waiver. You have options.
FAQs
In most cases, you must be 55 before taking money out of your pension. However, you do have the ability to access the funds before you retire, granted that’s after age 55. You must also have worked a minimum number of years with the employer in order to be eligible to receive the pension.
In certain situations, taking out a lump sum from your pension and using it to repay debts can be a good idea. However, you could incur early withdrawal fees and taxes on your withdrawal and have a lower monthly payment for the rest of your life. You should carefully weigh the benefits and drawbacks of using your pension to pay off debt before making a decision.
Yes, pension plan loans allow you to use your pension as collateral. However, borrowing from pension to pay off debt can be a risky gamble as a failure to pay off your debt will result in the loss of your retirement funds.
When looking at a loan from pension funds or simply evaluating different retirement accounts, it’s crucial to look at the varying types. There are six primary types of retirement accounts: 401(k), Traditional IRA, Roth IRA, SEP IRA, Simple IRA and Simple 401(k), and a Solo 401(k). Each of these accounts has its own benefits and drawbacks to consider.
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