By Kevin M
Despite the near sacrosanct status of tax sheltered retirement accounts, there are situations in which liquidation makes abundant sense. From the outset, let me say that I don’t advocate raiding retirement accounts except under extreme circumstances.
When to consider tapping retirement savings
My personal opinion is that if survival is at stake tapping retirement savings MUST be on the table. Under certain circumstances it becomes beyond absurd to allow your financial situation to collapse while protecting retirement savings. Retirement savings are, after all, a financial tool and not some sort of gold-plated legacy to be shielded at all costs.
Under what circumstances should we seriously consider withdrawal?
- When debt payments are so high that they threaten your ability to pay necessary expenses such as food and utilities
- When debt payments are so high that you’re loosing sleep; stress causes lost productivity and wears down our health, and we need both if we even hope to make it to retirement age
- When we’ve exhausted all other assets in a financial crisis
- When we’re flirting with disaster by having substantial debt and no liquid savings
- When we’re paying substantially more in interest on debt than we’re earning on our retirement assets (more on this point in the next section)
Even under any of these circumstances, we should consider other options before going the retirement liquidation route. Get a second job, cut expenses to the bone, liquidate non-retirement assets, sell personal possessions, and even consider selling your house or a second car. Drastic situations require drastic measures.
But let’s say you’re already doing some or all of those things, but you still can’t get out from under, what do you do? You do what ever you need to do. Remember, conventional wisdom is based on general circumstances; you’re personal situation might not fit neatly in that category.
High credit card debt is an effective margin loan
Items 1-4 above are largely self-explanatory, but I want to camp out on #5.
Having large credit card balances relative to retirement assets is the one situation in which I feel withdrawal or liquidation may be justified even though personal financial survival may not hang in the balance in any immediate sense. Here’s why…
If you have large credit card debt it represents an effective margin loan against the savings plan. True, there may be no legal connection between the two, but the financial connection is quite real.
Let’s be clear that what I’m referring to here is not periodic episodes of tapping retirement savings to clean up credit card balances. That’s plain poor financial management that needs to be addressed at a more basic level. What I’m referring to is when we might be carrying an unwieldy level of credit card debt which might be in need of a one time adjustment—a sort of self-imposed bankruptcy liquidation—so that we can truly move forward in improving the total financial picture.
Let’s do this by considering an example. If we have $30,000 in retirement savings and $25,000 in credit card debt, we’re not really worth $30,000. Our net worth—the value of our retirement savings, less the value of our credit card debt—is only $5,000. What ever thoughts we might harbor about our finances, this is the reality.
Ultimately, our finances aren’t a collection of mutually exclusive components, but a unified whole—and that’s how we need to approach it.
Using the numbers above, what are the relevant facts to consider in carrying high credit card debt while protecting retirement savings?
The situation is financially unsustainable. Let’s say we decide not to take any risks with our retirement savings, and invest the entire account in fixed rate savings vehicles of varying maturities paying an average return of 3%; if we’re paying an average of 13% on our credit card balances, that means we’re losing 10% in the exchange every year that we allow this situation to continue!
We might close the gap by investing in higher yield, higher risk vehicles, but when we do that we’re now matching uncertain returns against the guaranteed interest expense on credit card debt. The situation is completely unbalanced and will gradually, quietly and needlessly drain our resources.
Paying off credit cards is a guaranteed return on investment. This concept is broadcast all over the financial universe and it makes abundant sense. We’re in a uncertain economic environment with historically very low interest rates—how many guaranteed double-digit return opportunities are available right now?
Credit card interest is NOT tax deductible. All the time we’re paying it, we’re feeling the full force of it. This negates the tax advantages of retirement earnings, not the least of which since retirement savings are only tax deferred, not tax free. We will pay tax on retirement earnings at some point.
Some argue that by liquidating retirement savings we’ll have a guaranteed loss in the form of the IRS 10% penalty on early withdrawals, which is a fact. However, using once again our example of 3% guaranteed retirement earnings against 13% guaranteed interest paid on credit card debts, we’re losing 10% anyway. More significantly, the IRS penalty is a one time event, while the savings/credit card interest rate gap is repeated every year. We have to pay either way, but which is the lesser of the two evils?
We will have to add the amount of the retirement withdrawal to our income when we file our tax returns and there will be a cost for that. Assuming a 30% marginal tax rate plus the 10% withdrawal penalty, we’ll have to pay $10,000 on a $25,000 withdrawal. Where will we get that kind of money if we used the entire withdrawal to pay off our credit cards?
On a $25,000 credit card balance, we’re making minimum payments of $500 per month. If we liquidate retirement to pay off our credit cards in April of this year, by the time we file our taxes in April of next year, we can bank $6000 ($500 X 12 months) that we’ll no longer need to pay to our creditors. (Warning: don’t even attempt liquidation if you aren’t fully committed to redirecting payments into tax payments, or you’ll be trading one set of problems for another.)
Even if we don’t go through with this plan, we’ll still have to pay the same amount to our creditors, after which we’ll still owe something stunningly close to $25,000 one year from now. That’s just the way credit card debt works.
That’s $6000, where do we get the remaining $4000? Terminate retirement contributions and redirect equivalent funds to increase income tax withholdings until the full tax liability is covered. Don’t allow short term tax issues to prevent you from making long term financial improvements!
Sometimes we have to take a step back to go forward. This is an intangible factor, but one which is critical in reaching financial independence. If we’ve made mistakes in the past, such as accumulating outsized credit card debt, we can’t move into a better future unless we clean up our past sins. The sooner we do that the clearer the future will become.
In the example above, we will be liquidating $25,000 of retirement savings we now have, foregoing the tax deferred earnings on it, and not adding any contributions to it for as much as a full year. But remember, because we have $25,000 in credit card debt, our retirement savings are largely an illusion anyway. Because interest rates on savings are so low, we’re only giving up 3% guaranteed, or $750 in earnings. And the fact that we aren’t adding new contributions is only temporary.
Paying off debt is financial trench warfare, and there’s no cost-free, pain-free way to do it.
About a year after liquidating, we’ll still have $5000 remaining in retirement savings ($30K less $25K withdrawn to pay our debts), no credit card debt, no double digit interest to pay, no $500 per month payment to make, and we can resume making contributions to our retirement account at an even higher level because we have no debt. Sounds like a solid start to a brighter future.
Reminds me of the line in “City Slickers”–It’s a do-over!
Sometimes that’s exactly what we need. Wipe the slate clean and start over.
(Note: the example presented above is an illustration of a situation that isn’t at all uncommon. However, since all situations are unique by details and by degree, consider this only as a guide to one way of handling your particular situation. Not the least of which because there are tax implications, any step of this nature should be carefully considered against the specific issues in your own situation, and should be discussed thoroughly with trusted and knowledgeable advisors.)