Taking money out of an IRA to pay your debt is almost never a good idea. You should only consider it in dire financial crises. Even then, it may make sense to endure the short-term consequences to ensure your retirement.
- There are penalties and fees associated with pulling money out of your retirement accounts early.
- When you take funds out early you minimize the effects of compound interest for your money.
Never consider using funds from your IRA to pay your debt unless it is a dire emergency. Even then, ask yourself if it is worth it to alleviate the short-term suffering at the expense of your retirement.
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Rules and Penalties for Early Withdrawal
If you take funds out of your retirement account before 59 ½ then you must put it into another IRA or else the Internal Revenue Service (IRS) considers it a taxable rollover. That means your withdrawal is subject to taxes and penalties. These depend on what type of retirement account you have:
- 401(K) – 10% penalty; taxes depend on what bracket you’re in, but the IRS usually holds 20%
- Traditional IRA – 10% penalty; taxes depend on your bracket, but the IRS doesn’t withhold any
- Roth IRA – No penalties or taxes on the principal; 10 early withdrawal fees on earnings
These accounts are meant for retirement. If you take out money early, you are stealing from yourself in a sense. Don’t think about using this unless it is a catastrophic financial crisis like bankruptcy or foreclosure.1
There are emergencies where you may need to take out funds, and the accounts have some exceptions built-in for you to do this. You still must pay taxes, but the fees are waived in certain situations.
Both 401(K) and IRA
- Death or permanent disability
- Medical expenses
- Military called to active duty
- IRS levy payments
- Rule 72(t): some people use substantial equity periodic payments (SEPP) as a way to retire early
- You leave your job at 55 (50 for some government positions)
- You overcontributed
- You use the money for qualified higher education expenses
- First-time home buyer
- You use the funds to cover health insurance premiums when unemployed
These are short term loans, and you must pay them back in 60 days. If you don’t, there is a 10% penalty. You pay interest, too. So, you borrow from yourself with interest, and if you don’t pay it back then the IRS penalizes you more.
Dave Ramsey says, “the truth is, you can’t borrow your way out of debt, so you should avoid loans altogether.” We can’t say it any better than that. Don’t borrow against your retirement, ever.
Should I take money out of retirement to pay off debt?
You should almost never take funds out of your retirement accounts to pay off debts. Only when you are in an extreme situation should you consider it. Here are two cases where you might consider it:
- Bankruptcy – The prospect of losing your possessions and destroying your credit may lead you to tap into retirement savings to avoid it.
- Foreclosure – Losing the roof over your head may put enough fear into you to take money out
These are both very bad situations, and it’s understandable why anyone would leverage their retirement money to get themselves out of either of these financial holes.
Even so, we argue that it is better to take the financial consequences of bankruptcy or foreclosure now rather than use your retirement money. Right now, you can still work and repair credit. Later, you can’t. Right now, you can still change your spending and savings habits. Later, you can’t.
Another reason not to is compound interest. If you leave your money in your retirement accounts interest accrues on the principal. This gets rolled into the principal for the next period. It has a snowball effect. In the beginning, it grows just a little bit. But after a few years, it begins to build momentum, growing faster and faster each period.
The longer you leave your money in a retirement account the longer it compounds. And the longer it compounds the more exponential growth you see. If you disrupt the compounding by taking money out you lose a lot more than just the interest, fees, and taxes. You lose the potential growth of the principal through compounding.
Before you raid your retirement accounts remember what they are there for, to make sure you have money when you can’t work and earn anymore.2
Impact of Taking Money Out of an IRA to Pay Debt
Taking money out of your retirement account to pay the debt is a dilemma. Is it a good idea to jeopardize your retirement to deal with an immediate financial crisis? As hard as things may seem right now, there is almost no situation that warrants raiding your retirement accounts for your present situation.
The damage to the compounding process is catastrophic and can’t be undone. Taking money out, or even borrowing against your retirement, drastically reduces the amount of money you will have later.
You have options today to deal with problems. You can refinance, negotiate terms, and even mediate with your lenders. Beyond that you can declare bankruptcy. This affects your credit and lowers your standard of living now. It may be very hard for a while, but with time, hard work, and good financial management you can rebuild credit ratings, wealth, and possessions.
After you retire your options for earning income and managing debt drop dramatically. It is better to deal with your present problems now rather than robbing from your future self.