What do you have planned for your retirement? Travel? More time with family? Hobbies? A new business venture?
Encountering a large amount of debt as you enter retirement may shrink your options.
Clients who are facing this obstacle come to me asking, “Should I use my retirement savings to pay off debt?”
The short answer is no, unless it’s unavoidable. Why do I say this?
1. There are considerable tax implications. 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comes from an IRA, a 401(k), or a similar tax-deferred retirement account, you will owe income taxes on all the money withdrawn.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.
2. You may incur an income tax penalty. 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.
A 401(k) plan is required to allow participants to take a hardship withdrawal. Under certain circumstances, you might have to repay the debts, but these distributions are also fully taxed and subject to penalties, if applicable.
3. 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.
4. You may start to regard your retirement account as a piggy bank. Retirement savings should be left alone to compound for retirement. These plans were not designed to be saving accounts, hence the steep tax penalties for early withdrawal.
If you absolutely must use retirement savings to pay off debt, make sure you get the biggest bang for your buck.If you’re paying off a mortgage, mortgage interest is tax-deductible. You have to look at the after-tax cost of the loan to determine your rate of return from paying off the mortgage. Credit card debt is not tax-deductible and generally carries a higher rate of interest than a mortgage. Compare the interest saved with the potential forgone return on investment and the tax liability associated with the retirement plan distribution to get an idea of your return from using retirement savings to pay off debt.
Roger Wohlner, CFP®, is a fee-only financial advisor at Asset Strategy Consultants in Arlington Heights, Illinois. Roger provides advice to individual clients, retirement plan sponsors and participants, foundations, and endowments.