Find yourself thinking about Paying off Debt with Retirement Accounts, or otherwise picking between the two? Is it a good idea to use your 401(k) or Retirement Accounts to pay off student loans or credit card debt? In addition, what are some general rules of thumb to consider beforehand?
This post covers what we’ve considered as part of our decision making process; use it as you consider and decide upon a course of action.
CONSIDERATIONS BEFORE PAYING OFF DEBT WITH RETIREMENT ACCOUNTS LIKE 401(K) OR IRA:
Paying off debt with retirement accounts is not something to be taken lightly. Whether student loans or credit cards, debts can certainly be overwhelming. However, paying off debt with these dedicated retirement instruments could prove more costly than expected. Especially over time. Whether cashing out, borrowing or otherwise accessing your retirement funds, it is important to be very careful. I recommend meeting with your trusted financial advisor who is aware of your unique financial situation before taking any actions.
Opportunity cost of Paying off Debt with Retirement Accounts (and Interest!)
It is possible that your 401(k) and IRA type retirement accounts are earning more interest than you are paying out in student loans. In those cases, your dollars are working hard to make your retirement better, and diverting those dollars into your debt could be more costly in the long-term.
Credit cards are another beast, but I think the same rules generally apply. I think there are other ways to deal with your short-term problems without divesting your long-term benefits in retirement.
Tax Impact (short and long-term) of Paying off Debt with Retirement Accounts
Taxes are another key factor and should be carefully reviewed with a finance professional intimately aware of your financials. Keep in mind that early withdrawals from retirement accounts costs you money right off the bat (e.g. 10% early withdrawal penalty if taken before age 59 1/2).
Also, and somewhat related to the first point, many retirement vehicles offer various tax-advantaged benefits that should be leveraged to the extent possible. For example, a traditional IRA ‘current’ tax benefits while ROTH IRAs offer ‘later’ tax benefits.
Know the Penalties of Paying off Debt with Retirement Accounts
Depending on what nest egg you’re tapping into, your age relative to the retirement rules from the IRS, and what you spend the withdrawals on, there could be more penalties beyond the 10% example above. As with the other points, consult a trusted advisor. Know what you’re getting into!
Habits and the Time-Value of Money
Once you allow yourself to draw from the proverbial retirement nest egg it makes it easier every time. “Check yourself” first – the larger your balance grows the more tempting it could be to do it again.
Credit card debt can always return, and interest on federal student loans is at least tax-deductible. Avoid drawing down your retirement account to address short-term problems as doing so could create a bad habit that only hurts your financial situation more over time.
Political Landscape and Laws
Another consideration to keep in mind is the ‘taboo’ topic of politics. It is a good idea to be familiar with and understand what the laws, stimulus packages, etc., are for the current administration, regardless of political affiliation. For example, if there is an executive order or legislation that could result in student loan forgiveness it might make sense to structure your debt repayment plan differently.
Mêtis in your ‘Savings vs. Paying off Debt’ Matters
Sometimes we feel we are faced with the option of paying off debt or saving for retirement, and that there can be only one of the two. I would strongly encourage you to ‘find another way’ if at all possible and avoid using retirement dollars for anything other than retirement. Don’t give up on “tomorrow” for the relief of today’s problems.
Thriving, Saving for Retirement, and Paying Off Debt
We took aggressive action! We have stripped-down to our bare minimums with expenses, I was fortunate to start over in a new career field with a raise, and we mercilessly hacked away at debt (prioritizing high-interest first).
Along the way, we continued to contribute to our 401(k) up to the point where the company would match. Striking a balance between where we are today and where we wanted to be tomorrow has worked well for us!
Taking advantage of Benefits as you go!
Everyone’s situation is different. Student Loans are the target for us, and our plans revolve around destroying that debt. As I mentioned above, we still contribute to our 401(k) so as to collect the match from my company. Additionally, interest on our federal student loans is also tax-deductible (current benefit) and in the case of our ROTH account, the earnings are not taxable (future benefit).
All that said, take a moment to survey the landscape of your personal finances and come up with a balanced plan that aggressively tackles debt while not forfeiting the future: paying off debt with retirement accounts may not be the best option after all! Best of luck to you, my friend: the future has never been brighter!
Here are a few more posts that might interest you:
- Motivation with Your Money
- A Practical Financial Strategy during COVID-19
- Your Personal Finance Journey
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