My husband and I have been in your shoes before. Our individual and collective debt footprints spanned whatever kind of space $59,492 takes up. By the time we were engaged, we had $25,000 left to pay off and were desperate to get out of it. Why? Because we didn’t want to enter our marriage anchored by past decisions and obligations (unfortunately ‘his’ and ‘hers’ does not always refer to positive things).
Once we created this goal, no idea seemed too extreme to try and achieve it—completing online surveys, taking part in paid focus groups, pawning my old boyfriend’s gifts of jewelry, mystery shopping, cutting our monthly food budget to just $250, etc. We were willing to do almost anything to get out from under our debt by our wedding day.
That is, except to raid our retirement plans. And specifically Paul’s 401(k).
At this point in our lives—I was 27 and Paul was 29—we each had a Roth IRA and Paul had a matching 401(k) with his company. Paul was a late starter with his retirement plan, and had just opened up each of these accounts two years earlier. I had always valued the need to save extensively for retirement and so had opened up my Roth IRA when I was 23. I certainly did not want to raid all of the work I had put into saving for my future, so taking money from my Roth IRA was out of the question. Taking money from Paul’s 401(k) also did not make sense to us, but mostly for other reasons.
Let’s first take a look at why you should typically not take money out of any retirement plan in order to pay debt, and then how it makes even less sense to take from a 401(k) plan.
Why You Should Leave Your Retirement Account Intact
I don’t think it’s a good idea to take money from your retirement accounts to pay off debt. There are many factors that have gone into forming my decision on this, mostly centered on the idea that you need to be saving as much as possible whenever you can for retirement, not taking away from it.
For one, the future is unknown. You can pay your bills today (hopefully), but that’s with a steady paycheck coming in. How are you supposed to pay your bills during retirement without a steady paycheck now that your retirement savings are diminished? On top of receiving less money each month due to taking money out when you are relatively young, you have no idea what the income tax brackets will look like far into the future. Taxes tend to increase, not decrease, and any future increase would further eat away at your monthly income. Another reason why it’s best to keep your retirement savings intact (plus save as much as you can) is the unsecure Social Security system that has been largely bankrupt (or steadily heading in that direction). If you are around my age (30), you should not be building your retirement dreams or needs on social security. Finally, depending on what type of retirement account you have, you may have to pay income tax on any money withdrawn, which means taking that money out diminishes its current and future spending power considerably.
In other words, your money is best left sitting in your retirement accounts, earning money on top of your earnings.
What Happens When You Take Funds from Your 401(K) Plan
Raiding a 401(K) is even worse than raiding a Roth IRA account. Why is that?
There are two ways that you can take money out of your 401(k): through a loan that you need to pay back, or just by taking the cash. If you take a loan out of your 401(k) to pay off debt, then you’ve merely done a debt swap. You will not achieve your ultimate goal of debt freedom, though perhaps it will feel like you have (a dangerous game to play). On top of that, you have to pay the money back with after-tax money (meaning any tax savings previously gained is lost). If you are suddenly terminated—whether your fault or not—you have to pay the loan back plus interest immediately (which could put you in quite the pickle as people generally need to cut expenses when they lose jobs, not increase them).
Unlike a Roth IRA where you can technically take out all of the money you have put into the account without a penalty, there is a stiff penalty you will incur when taking funds out of your 401(K). According to the IRS, an early distribution will cost you a 10% penalty as well as income tax on the amount. Not to mention you will lose out on the type of compound interest you get when you allow your investment earnings to earn more money.
Alternatives to Raiding Your 401(K) for Debt Repayment
So what should you do if you need money for debt repayment instead of raiding your 401(k)? Unfortunately, the answer is not glamorous: you need to forge on with your debt payment strategy. If you are looking for some mini-windfalls to throw on your debt—a mini-version of what you were hoping would come from your 401(k)— then think about taking your tax return check, or your two extra paychecks each year (if you are paid bi-weekly) and dedicating it all to your creditors. Check out some other unconventional ways to pay off your debt more quickly.
Even though it might sound enticing to take out a loan from your 401(k) or to cash out altogether in order to pay off high-interest credit card debt, it generally does not pay off in a financial way. Any ground gained is usually forfeited by penalties and lost time and earning potential you’ve given up by not leaving your retirement plan intact.
Image Credit scottwills