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Many people come to a financial crossroad. That moment when you finally realize you have more debt than your budget can handle, and you’re ready to make a change. An immediate change. Like, right now. You want to pay everything off and start fresh, and continuing to make monthly payments feels too slow.
Since you’ve been working for a few years now and have a nice little nest egg built up in your retirement account. It’s actually enough to pay off most of your debt. You start thinking about this as a possibility:
- “I’m young – I still have time to rebuild my retirement fund.”
- “Some of my friends don’t even have a 401(k) yet.”
- “Withdrawing this money could eliminate my debt and my stress.”
- “The penalty for withdrawing is just 10%, but my credit card interest is 18%.”
Realizing the negative implications of being in debt and the stress it brings to every aspect of your life is the critical first step. Once you see it and feel it and understand it, there is an urgency to tackle it.
It can be very tempting to liquidate your retirement assets to pay off a big chunk of high-interest debt and wipe the slate clean. The logic SOUNDS good. But, using your retirement money for this purpose may hurt you more than help you.
So, before you cash out your dedicated retirement funds, let’s take a look at why this logic is faulty.
Do the Math
When it comes to getting out of debt, it’s important to see progress and see it quickly. It becomes like a race to watch your debt shrink, and that keeps you motivated. But it’s equally important to do the math up front, so you aren’t just doing what “feels best.” Emotions and feelings make a huge impact on our financial decisions, however, you need to think about the consequences of your decisions before jumping in with both feet. You need to do what feels right, but also make an informed decision.
You want to make the choice that’s financially the smartest – the one that leaves you with the most money at the finish line. Even if your credit card interest is higher than your tax rate, it’s not a smart idea to withdraw your retirement savings early.
To Withdraw or Not to Withdraw, That Is the Question
Let’s assume you have $5,000 in credit card debt with an average interest rate of 15.96% (many are as high as 21%). If you continue to make the minimum payment of $100 each month, it’s going to take you 7 years to pay off the debt. Not only that, you will have paid an additional $3,274.48 in interest.
You can choose to liquidate your retirement fund now, immediately pay off that debt, and save yourself 7 years of payments and over $3 grand in interest. After all, you still have your job, and you can have that amount built back up in a reasonable amount of time, right? You can eliminate the debt AND significantly free up your monthly budget!
It’s easy to see how the high-interest rate that comes with credit card debt makes using your retirement money SEEM like a good idea. It’s difficult to understand how the interest you earn on your investment could possibly be more than what you’re paying back on your debt.
Here’s where doing the math is important.
If you withdraw your retirement money, you miss out on the investment you’ve worked to grow to this point.
Since we’ve assumed you have $5,000 in debt, let’s also assume you have $5,000 in your retirement fund at this point. Based on a 40,000 yearly income, with the standard 4% going into your retirement fund and 30 years left before retirement, here’s what the numbers look like:
- If you withdraw the $5,000 and start with a zero balance in your retirement account now, you may still accumulate a balance of $469,471 at retirement (with an out-of-pocket expense of just $76,121.)
- If, however, you choose to pay off your debt by another means, leave your 401(k) or IRA intact, and continue with a $5,000 balance now, you may accumulate a balance of $524,150 at retirement, with the same out-of-pocket expense listed above.
In other words:
- Use the $5,000 to pay off your debt now and save $3,274.48.
- Leave the $5,000 growing and save $54,679.00!
Three thousand versus FIFTY thousand! No contest!
Once you do the real math, the choice is obvious. (Remember, this is based on the above criteria. If you make a higher income or contribute a higher percentage or have more in your retirement to start with, the numbers increase dramatically.)
It Just Doesn’t Add Up
Other factors to consider when “doing the math” are the penalties and taxes you will incur when liquidating your retirement funds.
First, you will pay at 10% penalty for early withdrawal. Second, most money in traditional retirement funds like a 401(k) or IRA is pre-tax money so you will be required to pay income taxes on the amount you withdraw. Depending on your income and tax level, this could be anywhere from 10% to 30%.
Withdrawing from Your 401(k) or Other Qualified Retirement Plan
- Cash out…………………………………………. $5,000
- 10% Early Withdrawal Penalty …………-$ 500
- Federal Income Tax withholding ……..-$1,000
- Total Amount You Will Receive………… $3,500
You lose at least 30% right off the top for simply withdrawing the money. If you’re withdrawing $10,000, you will pay a $1,000 penalty and about $2,000 in income tax. The more you withdraw, the more you stand to lose.
It’s safe to say that these numbers just don’t add up. Barring extreme circumstances, you’re better off paying off credit card debt the long way. Even if it felt like a good option, in the beginning, using your retirement money to pay off debt doesn’t make good financial sense.
Still, there is debt to be paid, and the sooner, the better. Thankfully, there are several alternative approaches you can consider.
CONSIDER OTHER OPTIONS FIRST
First and foremost, make a budget. Track your spending and find ways to cut corners. Even when you think your budget is already tight, the chances are very good you can eliminate non-essentials like eating out or adjust the thermostat or carpool to work… and put the money you save toward your debt.
While you’re at it, boost your income. Take on a second job or sell unused items in your home to bring in some extra cash. You’ll be surprised what a difference this option will make.
Second, consider making a balance transfer from a high-interest credit card to a 0% interest card. This can buy you a little time without interest. The key is you need to pay off the balance that you transferred before the introductory 0% APR ends. Or check out Debt.com for other ideas on how to handle your credit card debt.
And third, choose between the Snowball Method and the Avalanche Method for paying off your debt. The Snowball Method takes the approach of paying off debt from the smallest to the largest, putting each subsequent payment toward the next. While it’s not quite as cost-effective as the Avalanche Method, but it helps you see progress a bit faster.
The Avalanche Method, on the other hand, is a debt-reduction strategy that focuses on knocking out the highest-interest balance first. If we’re doing the math, this method is more efficient and saves you the most money.
The moral of the debt-repayment story is: there are many ways to pay off your debt without using the money in your retirement fund. You’ve worked hard to save that money to this point. Leaving it alone and letting it grow is the biggest financial favor you can do for yourself.