Should You Pay Off Debt With Retirement Funds? Tips For Greensboro Consumers Skip to main content

You are here

Should You Pay Off Debt With Retirement Funds? Tips For Greensboro Consumers

Print

401(k) loan

Debt now versus retirement later

Image by geralt via Pixabay

Debt isn’t always a bad thing. It’s debt that lets you buy a house or a car – two things most Greensboro consumers could never purchase on a cash basis. If you can service your debt on your current income while still paying your costs of living and saving for retirement, you’re probably just fine.

For those living paycheck to paycheck, unable to save, and being hassled daily by collection agents, debt is awful. Should you tap into your retirement funds to pay off your debt? If you ask your creditors, they will tell you yes because they want their money, but it’s probably a bad idea.

Retirement funds are your future

In most cases, tapping into your 401(k) to deal with debt is a terrible prospect. That’s money you’ve set aside for your future when your income-earning days are behind you, and you’re ready to slow down. However, it can be tempting to dip into them if debt collectors are hounding you and your golden years seem too far away to cause concern.

Understand that if you touch your retirement funds to deal with current debt, you’re short-changing your future, and this could be one of the biggest mistakes of your life. It’s much better to tighten your belt, slash expenses, sell off assets, or take a second job before you touch your 401(k) to service debt – even if that debt is your mortgage or auto loan.

The harsh penalties of withdrawing retirement funds

Apart from the fact that draining your 401(k) compromises your ability to support yourself when your best work years are behind you, there are significant penalties as well. The dollars and cents impact of pulling money out of your retirement account before age 59 ½ include:

  • You will lose interest you were earning on those funds
  • Any money you withdraw is taxable income
  • All funds are subject to a 10% early distribution tax

That means that right off the top, for every $100 you access, you’ll have just $90 in your pocket. Then there’s the income tax impact. If you’re in a 15% tax bracket, that cuts your cash in hand down to $75. When you factor in the interest you’re losing over time, that 25% can feel more like 50-70%.

Would you take out a 50-70% interest loan to pay off your debt? Of course not. That’s essentially what you’re doing when you use retirement funds to service debt. However, there are a few exceptions for using 401(k) funds where you’ll pay income tax but avoid the 10% penalty including:

  • You become disabled
  • You are 55+ and left the employer that hosts your 401(k)
  • You take out money for an allowable medical expense
  • You use the money to pay child support or alimony under a court order
  • You withdraw equal periodic payments under IRS rule 72(t)

A smarter way to leverage retirement funds

There is one method to use your 401(k) funds now to tackle debt without putting your financial future at risk, but it still has some downsides. Close to 20% of those with 401(k) accounts have a loan against their funds, and this can be a strategic move if done wisely.

Technically, it’s not a loan because there is no creditor involved in the transaction. In essence, you’re borrowing from yourself. You’ll pay back a bit more than you borrowed, but you’re paying it to yourself. Here are some of the benefits of a 401(k) loan:

  • You can request the loan and get the funds in less than a week
  • You won’t get dinged by a credit check that could lower your FICO score
  • You have up to five years to pay off the loan
  • You won’t pay a loan origination or other fee to access the funds

The downsides to borrowing from your 401(k) are:

  • You will pay income tax on the interest, so if you pay $400 in interest to yourself and are in a 15% tax bracket, your tax impact will be $60
  • If you leave your job with the loan outstanding, the remaining loan balance becomes a taxable distribution, and you’ll face the 10% penalty plus income taxes
  • If you default on the loan, the same applies, and you’ll pay income tax plus the penalty

Better options for debt payment

Consumers with overwhelming debt should consider all the alternatives before they dig into their retirement account. If you have a short-term need, such as a major car repair or a one-time medical procedure, it might not be so bad, but only under a loan scenario.

However, a better alternative might be to consider Greensboro bankruptcy. For those with mostly unsecured debt such as credit cards and medical bills, Chapter 7 can wipe those out in about four months, and your retirement funds will not be at risk.

For those with delinquent balances on their mortgage and auto loan, Chapter 13 can put you on a repayment plan to catch up on that debt while also seeing relief on unsecured debt. Plus, debt discharged in bankruptcy has no tax consequences.

Before you take funds out of your 401(k), talk to an experienced North Carolina bankruptcy attorney about your debt dilemma to see if bankruptcy might be a better option. The advice is free and could be life-changing.

To find out more about the benefits of bankruptcy, contact the Law Offices of John T. Orcutt. Read client reviews and then call +1-919-646-2654 to schedule a free Greensboro bankruptcy consultation at one of our locations in Raleigh, Durham, Fayetteville, Wilson, Greensboro, Garner or Wilmington.

 

 

Resources:

IRS Section 72(t) Periodic Payments

Debts Hurt! Got debt? Need help? Get started below!

What North Carolina County Do You Reside In?