Should You Use Retirement Savings to Pay Off Debt?

Despite the near sacrosanct status of tax sheltered retirement savings 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?

  1. When debt payments are so high that they threaten your ability to pay necessary expenses such as food and utilities
  2. 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
  3. When we?ve exhausted all other assets in a financial crisis
  4. When we?re flirting with disaster by having substantial debt and no liquid savings
  5. 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)

Should You Use Retirement Savings to Pay Off Debt?
Should You Use Retirement Savings to Pay Off Debt?
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; your 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 1%; if we?re paying an average of 13% on our credit card balances, that means we?re losing 12% 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 1% guaranteed retirement earnings against 13% guaranteed interest paid on credit card debts, we?re losing 12% 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 $6,000 ($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 $6,000, where do we get the remaining $4,000? 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 1% guaranteed, or $250 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 $5,000 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, including a CPA, tax attorney or other tax preparer.)

( Photo by SalFalko )

22 Responses to Should You Use Retirement Savings to Pay Off Debt?

  1. good post, tough question.

    The only way I would use retirement money for debt is if you were in danger of being homeless and put on the street. Otherwise, I would try to find another solution. (sell stuff, downsize, extra jobs, get rid of things you can do without like cable-TV, cell phones, internet, magazine subscriptions, sell that car and get a junker, etc, sell your home). There are too many other options to use before tapping into retirement money.

    I’m not sure you should use retirement money if you have not solved the poor money habits that got you into debt in the first place! You could use the money to pay off debt, and 3 or 5 years later be in the same boat again– but this time with NO retirement money because you spent it!

    Saving any money is tough these days. If you use the retirement money, there is a good chance that you will never save that money again. It’s gone forever.

  2. Arthur – I agree, it should and must be a last resort. However at some point it has to be a serious consideration. Having substantial retirement assets while drowning in debt isn’t any kind of financial planning.

    True, learning money management is a prerequisite–that’s why I wrote not to even try this unless you’re committed to redirecting monthly payments to taxes. That alone can help one achieve financial discipline by forcing you to save. Continue saving after the tax bill is paid, and you’re on you’re way to financial salvation.

    As far as being in the same boat in 3-5 years, that’s true as well, except that you’re already in that situation now!

    I think there’s a tendancy to think we’re better off than we are because though we may have debt, we also have retirement assets. That can be dangerous thinking that supports a continued path of overspending and to debt destruction. The cost of keeping debt is usually higher than the return on a comparable amount of retirement savings, so continuing the game actually works against us.

    That’s the same as someone who keeps borrowing money against his house because the house is increasing in value. His situation never actually improves because his debts always rise to match his assets. In the meantime his cost of living rises relentlessly because he’s accustomed to buying more than he can afford and because both his debt and his debt service rise relentlessly.

    As we’ve seen with the housing/mortgage bubble, for most who played that game, it didn’t end well.

    Thanks for a thoughtful comment!

  3. Consider sacrificing and gazelle intensity before dipping into your retirement to pay off debts. You are likely to fall right back into debt if you don’t change your behavior. Taking the easy way out by cashing in your retirement is not addressing the root of the problem. Sacrificing now will preserve that retirement account and help put you on a track that will keep you out of debt in the future.

  4. BibleDebt – Absolutely! What I’m proposing is a last ditch effort. None if this will work if there’s no financial discipline. But then again, NO financial plan can work without discipline, so continuing in the same way, building up both debt and retirement savings, will fail as well.

    Sometimes the best approach is to clear the decks and start fresh. At least in doing that the illusion of wealth is removed.

  5. Great line! “Retirement savings are, after all, a financial tool and not some sort of gold-plated legacy to be shielded at all costs.”

    It’s amazing that some folks would rather go the grave than take a couple steps back and use their retirement savings.

    On the other hand, I’ve seen way too many people very eager to hit up the retirement pot to pay off debt, only to find themselves in the same situation a couple years down the road – except worse b/c their retirement savings has been depleted.

  6. Jason – It’s most definately a balancing act, that’s why I tried to frame it as a one time event, or a self-imposed bankruptcy. The fact is, if you owe more in debt than you own in assets of all types–including retirement accounts–you’re technically bankrupt anyway!

  7. Kevin,
    I agree that there might come a point when today is much more important than tomorrow. It should be a last resort, but still a valid option.

  8. Craig, exactly, all things are subbordinated to survival. That isn’t something to be taken lightly, but if the time comes, it has to be considered.

    Sometimes we can get caught up protecting things–like certain assets–when our primary concern needs to be the people in our care, like our families.

  9. I actually googled this question and wound up at this website with this article. I am 65 and still working and have adequate funds in my retirement accounts to pay off my cc debt incurred through divorce and education expenses for my children. The card companies have recently raised my rates, one of them to 17.9% and I am furious about it but can’t get them to reduce. If I wait until I retire my tax implications will be less but I’m wasting lots of interest until then,????

  10. Jim, If you’re going to retire soon, you may want to payoff the debts as soon as you retire. Debts costs more than it earns on a equivalent amount of savings, and if it’s one thing you don’t need going into retirement, it’s monthly payments on old obligations. Could you take a second job to whittle down the debts before retirement?

  11. Thanks for the advice – I’ve been struggling with this one. Your numbers match mine – I’m losing money especialy now that I’ve seen interest rates on $30,000 in card debt increased to 15% even though I have excellent payment history. My retirement accounts are over $70,000 and I’m only 40 – A do over is in order. Will shred last 2 cards and save up for the taxes – 1 year to go.

  12. Maddi, that $30,000 in credit card debt is like a margin loan on your retirement savings. Maybe you can split the amount to be paid between a retirement withdrawal and other sources, like higher monthly payments or use of any non-retirement savings you have.

    Unfortuanately, a credit card debt of that size can grow and grow, so you want to get rid of it as soon as possible.

  13. Kevin,

    Thanks for the great post. I?m hoping to get a little financial guidance.

    I’ve inherited an IRA ($75,000) as a result of my Mother’s passing and will get another $30,000 from the sale of her home (when it sells, hopefully within the year). I have student loans for a total of $44,000 at interest rate of 7.75% (already consolidated). I am 53 years old and single.

    I am thinking of paying off the student loan with the inheritance money because I will probably not get that high of a return in the market and because it would be really nice to be out of debt. I am currently in deferment with the loans because I can?t afford the $365/mo payment. This adds about $100 of interest to the balance every month. I make around $30,000 a year and have a disability with my hands that holds me back.

    My plan is to immediately pay the loan down $14,000 out of the IRA and to wait until the house sells, then pay the rest with the money from the sale of the house. I have been told that I will not have to pay taxes on the $30,000 because it is part of her estate and thus part of the inheritance. If that is the case, it is better that I wait until the house sells rather than use the IRA money to pay off the whole loan.

    This will get me pretty much debt free and I will have $55,000 + left in the IRA. I don?t own a home and have no car payment. I might even be able to save money after that.

    I want to do what is best for my future and I can?t afford to make the wrong decision at my age. I would appreciate any feedback.


  14. Hi Bill–If you’re certain that there will be no tax liability as a result of withdrawing $30,000 from the IRA, then by all means, use the money to paydown the student loan debt. Please be sure to discuss this with your tax preparer/CPA first to be certain–when it comes to income taxes, general advice doesn’t always apply to specific situations! (What ever you do, don’t skip this step!!!)

    Money movements of this magnitude are seldom as simple as we think! The carpenters adage of “measure twice, cut once” is the order of the day.

    Also, I calculate that the interest on your loan is more likely building at a rate of about $280/month, so that’s another reason for moving quickly on this.

    For what it’s worth, I think your goal to be debt free is the way to go at your age. If you can get the debt paid off, and still have some money left over for investing, you’ll be giving yourself plenty of breathing room to move forward.

  15. I have an inherited IRA as the result of my mother’s passing. I have a little over $180000 in right now. I am considering paying off two personal loans with high interest rates and also paying for my first child to head off to college. I would need to withdraw around $40000 in order to do this. Would this hurt me too much in the long run with taxes? We are a below average income family of four (combined $82000). Thanks for any advice.

  16. Hi Angie – You MAY be able to set up distributions of “substantially equal payments” (72t distributions) that will lower, but not eliminate your tax liability. I’m not sure if that’s possible with inherited IRAs. My advice is to talk to a CPA about it. No one can answer that question without having intimate knowledge of your financial situation. You should also first try to handle the expenses with non-tax sheltered money to the greatest degree possible.

    And for what it’s worth, you’re not below average with income – far from it. The national median household income is in the $50,000 range. I believe that $82,000 puts you in the top 10%. Though I can fully appreciate it if it doesn’t feel like it most of the time.

  17. Question, I have approximately 100,000.000 in a decedent Ira, plus other savings. I am 62 and am carrying $30,000.00 in debt. I make a good income and would like to continue to work for at least another 7 to 8 years.I also have a pension that I will receive upon retirement. I would like to take a one-time draw from this ira to pay off the debt. I can then save and invest what I am know paying in credit card debt. My thought is, get rid of the debt now, while still making a good income to save and invest, because upon retirement my liquid income will be less than while I am working. Thought’s?

  18. Hi T.J. – That’s an excellent question. I’m thinking you mean that the decedent IRA is $100,000, not 100 million? I’m not your accountant or financial advisor, so this is just an opinion as to what I would do…I wouldn’t take the distribution to pay the debt. You will have to pay regular income tax on the withdrawal from the IRA, and since you make a good income, the tax bite could be high. You won’t have to pay the 10% early withdrawal penalty tax since you’re over 59.5, and that’s the good part.

    But since you have a good income, direct some of it to paying off the debt. For example, since you can generally contribute up to $6,500 (being that you’re over 50) for an IRA, instead use that money to pay off the debt. You’ll be debt free in less than 5 years, and the 100k IRA will still be intact, with no tax impact. Please also consider that if you want IRA money to pay off a 30k debt, you will have to withdraw more than 30k to cover the tax liability of the withdrawal. That can be even higher than you think if you have a state income tax to pay as well.

    Also, if you’re unable to make tax deductible IRA contributions, directing the money into paying off debt will make even more sense.

    That’s just my opinion. You’re in good shape no matter how you manage it.

  19. Hi Kevin,
    I’ve been contemplating drawing from an IRA to pay off $36,000 of CC debt. $28,500 is with an interest rate of 10.24% or more. Highest rate being 17.24% on $11,700. $7,700 is with an interest rate of 3.99% or 0%. $830.00 is 3.99% and 0% for a period of time on $6,900. I have $110,000 combined with my wife in the IRA. We had $116,000 last year at this time. We also have 403b’s. I have $38,000 and my wife has a little less than $30,000, I believe. We are currently only putting 3% into those because of our debt. I’m am stressed over the debt and who knows if we’ll even be around for retirement. What do you recommend? We don’t have an emergency fund. We have one year left of car payments and a year and a half of student loans. Then our daughter will be going to college. I have also thought of buying a new used car to lower payments but then I would be adding years of payments. Thanks for your response.

  20. Hi Stan – I’m not a CPA, lawyer or financial advisor, so this is “over the fence” advice, agreed? I certainly appreciate your desire to get out of debt. Having too much debt forces you to put your life on hold. But please avoid liquidating your IRA funds to do it. If you do, you’ll have to withdraw a lot more than the amount of your debt, because you’ll have to pay income taxes and an early withdrawal penalty of 10%. You may have to take out $40,000 to pay off $28,000 in debt.

    As an alternative, look into taking loans against your 403b plans. You have $68,000 in them, and you can generally borrow up to 50% of the balance (subject to a $50,000 maximum loan amount). The rate on the 403b loans will be a lot lower than the credit card rates you’re paying, and there will be no tax consequences. You’ll likely have up to five years to repay the debt to the plans. Once your car is paid off, you can direct the extra cash flow to pay off the 403b loans.

    This isn’t scientific, but I hope it helps!

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