Wednesday, December 5, 2012

Should You Use Retirement to Pay Off Debts?

Retirement (Photo credit: Tax Credits)
If you're experiencing financial stress, it can be logical to look for a source of money to pay off your debts. For most folks, the largest chunk of change they have is their retirement fund. But does it make sense to "borrow" from your future to pay for your past? Let's examine both sides: 

Pay Off the Debt 

Taking money out of your retirement account to pay off hefty debts can make sense. If you're over 59 and a half, you can withdraw from your account with no penalties. While you'll be taxed (at your income bracket) for the money, if the interest rates on your debt are high, it could still be worth it. Think about it like this: If you're facing a 20% interest rate on a credit card, but only a 15% taxation on your withdrawal, you're putting yourself ahead +5%. You can start putting that 5% each month back into your retirement account to build it up even faster. 

Plus, paying off your debt comes with a whole slew of benefits. You'll pay far less in interest over time, you'll improve your debt to credit ratio and you'll have more available money each month to save or contribute to your expenses. However, there are serious downsides to pulling the money from your retirement account. 

Don't Touch That Account! 

Every story has two sides, and debt repayment is one of them. If you're younger than 59 and a half, you'll face a 10% penalty for early withdrawal from your 401k. On top of that, you'll also face taxes on the money you withdraw. While you could still come out ahead, even with those mitigating factors, it's more of a risk. Plus, your retirement fund functions as savings for a serious emergency. If you find yourself unable to work for some reason, you'll want to have the money available. Using it to pay down debt could seriously weaken your long-term financial position if you're not careful. 

Other Factors to Consider 

If you suspect that you'll pay off your debt only to have it accumulate again, then absolutely don't borrow from your retirement fund. If you build the debt back up, you emptied your retirement fund for nothing. Using your retirement savings to pay off debt means committing to living as debt-free a lifestyle as you can manage. 

This is especially bad if you decide to pursue bankruptcy at a future date. Your 401k is typically protected under bankruptcy law, and if you emptied it only to rack up more debt, you may have lost a significant portion of your savings for essentially no reason. 

The Verdict 

If you think the penalties are worth it to you and you have a financial plan moving forward that includes far less debt, then pull from your retirement account. However, try to look for alternative solutions first. First, immediately stop accumulating new debt. Cut out the non-essential "goodies" from your life and put that extra money toward your debt. Look for a credit card with lower interest, if you can. Take steps to pay off your debt with your current income. 

Remember, at retirement, you can realistically only withdraw 4% each year to make sure your money lasts. If you have $600,000 saved up, that's only $24,000 a year. Borrowing from your retirement account now reduces your starting capital and decreases the amount of money you'll have each year in retirement. Although in some cases, you can withdraw money from your retirement account to pay your debts, it's never a decision you should make lightly. 

About the Author 
Carly Lance loves to blog about personal finances whenever she can. She also is employed as the blog and marketing manager at Personal Bankruptcy Canada, a company that deals with people going through bankruptcy in Canada.

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