by

Over the years I’ve been asked on a number of occasions if it is wise to tap retirement accounts such as an IRA or a 401(k) to pay down debts. Generally my answer is no. Here’s why I say this, especially for those close to retirement.

Tapping tax-deferred accounts

If the money comes from an IRA, a 401(k), or a similar tax-deferred retirement account, you will owe income taxes on all the money withdrawn. If you withdraw $10,000 and are in the 25 percent income tax bracket, you will incur a tax liability of $2,500. If you absolutely need to net $10,000, you will need to withdraw $13,333 for example.

If you are younger than 59½, you will incur a tax penalty of 10 percent on top of any normal income tax liability for a distribution from a tax-deferred retirement account. That $10,000 withdrawal would now cost you $3,500. There are a few exceptions to this rule.

If you are 55 and have separated from your employer you may be eligible to take penalty-free distributions from your 401(k). There are also exceptions for situations such as death and disability. This chart contains a list of the exceptions to the 10% early withdrawal penalty for 401(k)s, IRAs, and other tax-deferred retirement accounts. Before moving forward with any of these exceptions it would be best to consult with a qualified tax or financial advisor.

Some 401(k) plans have a loan feature and if this is available to you this is likely your best route if you absolutely need to tap one of your retirement accounts. There will be a limit as to how much of your account balance can be borrowed and the number of outstanding loans you can have at one time. Also be aware that if you leave the company before fully paying back the loan the unpaid amount might turn into a taxable distribution.

You’ll be behind in your retirement savings

You might have good intentions and say to yourself that once the debts are paid off, you will have extra money with which to build up your retirement savings. Some folks will be able to do this, but most of us will find another use for the money. Further, if you’ve lost a job or seen your compensation reduced, this is even harder to do.

Moreover there have been numerous studies showing that many Americans are behind where they should be in term of their retirement savings. Some say that a general lack of retirement readiness is an epidemic in the U.S.

The most recent survey by the Employee Benefit Research Institute indicated that only 14% of the employees surveyed felt confident that they would have enough money to retire.

The most recent survey by the Transamerica Center for Retirement Studies indicated:

Only 39% of the workers surveyed felt that they were building a sufficient nest egg to meet their retirement needs.

69% of those surveyed felt that they would not have accumulated enough in retirement savings by age 65 to meet their retirement needs.

Against this backdrop, in my opinion, using your 401(k) or other retirement savings to pay down debt should be done only after careful consideration and after all other alternatives are exhausted. You only have one shot at saving for retirement and this is a difficult enough task on its own. Tapping your retirement savings for other purposes creates a bigger mountain to scale.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email.

Photo credit: Flickr