Be Careful When Cashing Out a Retirement Account to Pay off Debt

It’s tempting to dip into retirement savings when you’ve got a large debt to pay off. That retirement money is sitting there in one large chunk, and you know that it’s supposed to be used for many years’ worth of retirement income, but it’s also painful to let debts linger.  The monthly payments might be a huge burden, and you may hate the thought of paying so much interest.

None of the choices available to you are perfect, but for some people the decision is simple: they want to completely eliminate debt, even if that doesn’t make the most sense financially.  If you’re that kind of person, that’s completely fine.  It’s just important to be aware that that’s the decision you’re making (bonus points if you’re mindful enough to figure out why).  You should also consider alternative approaches for the debt and rule out the ones that don’t fit.

Math or preference? In an ideal world, everybody would run some numbers and figure out what makes the most sense from a mathematical perspective (which one leaves you with more money in the end?), and then decide whether or not to make the “optimal” choice.  But that might not be as important (to some) as the psychological comfort to that comes from knocking out debts.

Types of debt: If you are going to cash out a retirement account to pay off debt, it probably makes the most sense to do this for revolving lines of credit such as credit cards.  Other types of loans (home mortgages, auto loans, etc) are not nearly as toxic as credit card loans.  However, again, it’s really a matter of personal preference.

Missed Opportunity, Temporary Benefit

Before you cash out a retirement account, there are a few things you should be aware of.  On the one hand, you can stop paying interest on debt, and your cash flow situation will improve.  On the other hand, your retirement money is gone, and you miss out on the potential to grow that nice pot of money that you worked so hard to accumulate.  In some cases, especially with high interest rate credit card debts, it’s hard to imagine how the money you might earn on investments would be much more than what you’ll certainly pay in interest, so paying off debt is a little more attractive.  Still, you’ll still have to repair your retirement account someday (which means that extra cash flow from the payments you eliminated probably needs to go into your retirement account).

Taxes, of Course

Piggy bank, pennies spilling out

Photo: Kat. CC-BY-2.0

Another important consideration is taxes.  If you pull money out of a retirement account, you may have to pay income taxes and penalties on the amount you withdraw.  This may leave you with a lot less money at the end of the day than you hoped for.  If the money was pretax money (from a traditional IRA or traditional 401k, for example) you’ll have to pay income taxes on the withdrawal.  If you’re under the age of 59 ½, you may also have to pay an additional 10% penalty tax.  Granted, you’ll probably have to pay the income tax someday anyway, but taking a large distribution from your retirement account can bump you into a higher income tax bracket (it’s like you got a huge bonus, but you won’t get to spend any of it).  You may want to see if there’s another way to pay off those debts without creating tax bills.

If you have a 401k plan (or similar plan) that allows loans, you can avoid the tax problem – as long as you repay the loan.  However, there could come a time when you change jobs, and then what?  You’ll have to either come up with the full repayment amount, or you’ll end up paying taxes and penalties on the amount you still owe because the IRS will consider that amount a “distribution.”

Protected Accounts

Retirement accounts are generally protected from creditors.  It’s hard for anybody to force you to use that money, whether it’s to pay off debts or to settle lawsuits.

Even if you go bankrupt, you may be able to keep some of your retirement money for later.  Local laws vary, and of course, the devil is in the details, but most states provide some level of protection for retirement assets.  If you take that money out of a retirement account, it is no longer protected.

Why might you enjoy the protections of a retirement account?  If you’ve fallen on hard times, cashing out the retirement account to pay off debts might just delay the inevitable.  If there’s any chance that you’re headed for bankruptcy, it’s probably best to leave your retirement assets alone.  You don’t want to be in a situation where you’ve cashed everything out, but you still go bankrupt anyway.  You’ll have to start over on your retirement savings when you might have otherwise been able to keep those accounts intact.

Unfortunately, creditors often ask about retirement assets first. They’ll suggest that you cash out and wipe out the debt because it’s the easiest solution (it’s easiest for them, but it causes problems for you).

Less Than the Full Amount

Less Stress and Less debt is only 30 seconds awayIf you’re considering using retirement money to pay off debt, consider paying off less than the full amount.  That way, you don’t do anything too drastic, and you can stay somewhat on course with both goals: saving for retirement and paying off debt.  Is there an amount that you can pay that will make your future debt payments more manageable (if you’ll be able to lower your monthly payments)?  Maybe you can start by just paying that amount.  If you want to pay more later, you can always do so.  Some people think of this question as all or none, but the reality is that you can choose to just make a nice dent in things without completely cashing out.

Other Ways

Maybe there’s another way. Instead of cashing out, would it work to just stop contributing to your retirement accounts? Your retirement savings will stall and the debt won’t go away as quickly, but you won’t move money out of a protected account or pay tax penalties.