At a Glance
Saving for retirement should be a priority, but it may seem less important when debt accumulates and financial unmanageability creeps in. Should you consider using retirement to pay off debt? The money is in your account. Your debt is accruing interest. It’s not difficult to talk yourself into borrowing from that 401(k) or IRA to become debt free.
There are other options, of course. You could simply make your minimum monthly payments and eventually your debt accounts will be paid off. That’s the long road. You could shorten it by trying the debt snowball or avalanche, both of which put you on a strict budget. We’ll discuss those more below. First, let’s look at the pros and cons of using retirement to pay off debt.
Should I Use My Retirement to Pay Off Debt?
You’re probably in a bit of a mess if you’ve reached the point where you’re asking yourself, “Should I withdraw from retirement to pay off debt?” The road to financial security is one where you’ll want to always move forward, not backwards. Do you want to pay off debt or save money that could earn you a return? Here are some arguments for both sides:
Pros of Using Retirement Funds for Debt Payoff
- Your Debt will Be Paid Off: You don’t need a loan payoff calculator to figure this one out. If you use your retirement funds to pay off all your debts, you’ll be debt free.
- You’ll No Longer be Paying High Interest Rates: High-interest credit card debt is a familiar problem in America. Pay the debt, eliminate the interest payments.
- Retirement Loans are Cost Effective: It’s not necessary to withdraw the funds directly from your account. You can take a 401(k) loan. They are low cost and you’ll be borrowing your own money.
Cons of Using Retirement Funds for Debt Payoff
- Early Withdrawal Fees: This is irrelevant if you take out a loan from your retirement fund but if you take money out to pay debt as an early withdrawal, you’ll be charged a fee.
- Additional Income Taxes: Any funds withdrawn from a 401(k) or traditional IRA will be taxed as income next year. Roth IRA withdrawals will not be taxed.
- Lost Returns: Retirement accounts generate a return because they’re composed of equities, ETFs, and bonds. Withdrawing funds will cost you potential returns while your money isn’t invested.
Is it wise to use retirement to pay off debt?
You’ll lose potential returns on retirement savings if you use your retirement funds to pay off debt, but you’ll also eliminate interest payments on your debt. It’s a wise move during down markets, but not during a bull market, when stock values are rising. In that scenario, it doesn’t make sense to use retirement to pay off debt.
Are there penalties for taking money out of your retirement account early?
There are penalties for early withdrawals from a 401(k) or traditional IRA, but not from a Roth IRA. Additionally, there are no penalties for 401(k) loans.
Other Options for Paying Off Your Debt
Let’s revisit the debt snowball and debt avalanche. Either of these methods is a good option if you need to pay off credit card debt. The snowball focuses on paying off balances from the lowest amount to the highest amount. The avalanche prioritizes paying off the account with the highest interest rate first. Other options to help you pay off debt include:
- Debt Consolidation: Taking out a debt consolidation loan to pay off credit card debt can help you lower interest rates and more easily budget your monthly payments.
- Debt Settlement: In some instances, credit card companies and lenders might be willing to negotiate a debt settlement for less than the total amount owed.
- Bankruptcy: This is a worst-case scenario. Bankruptcy could discharge your debts, but it will seriously affect your credit worthiness for several years.
Is Income a Factor When Paying Off Debt?
Trying to become debt free on a low income could minimize the options we’ve outlined above. For instance, the debt snowball and debt avalanche might be difficult to finance if you don’t have extra money to put toward debt. Even a debt consolidation loan could be challenging. If you’re struggling to make ends meet, that could weigh heavily in favor of using your retirement funds to pay off debt.
If you choose to go this route, try to get those funds back into your retirement savings account as quickly as possible and be vigilant about not taking on more debt. It’s only through careful budgeting and disciplined spending that you can remain debt free. Using retirement to pay off debt should never happen more than once.