Using your retirement fund to pay for debts is a bad idea. Let us just get it out there so you know that this is something that you need to be cautious of. The truth is, it is your money. Technically, you have every right to decide how and when to use it.
So why do experts strongly advise against the early withdrawal of your retirement money?
According to reports, barely 1 out of 10 boomers have enough money saved up for retirement. One of the reasons why this happened is because 17% of them ended up spending the money on something else. The report revealed that it was either because of desperation or even carelessness.
Despite the evidence of Baby Boomers having retirement fund troubles, the younger generations have no qualms about dipping into their own savings. They are giving so many reasons to justify it. Some say they are still young and they still have time to do it. Others compare themselves with their friends – saying that they do not even have a 401(k) yet. There are those who think it is worth it if it means getting rid of both debt and stress.
For the last part, some people might think that using their retirement savings for debt is really justified. If you feel the same way, do not be so hasty in making your decision. Get to know the real effects of withdrawing from your retirement fund. Only after learning the facts should you really consider using it to consolidate your debts.
Why consolidating debts using your retirement fund is not ok
Tapping into your retirement savings is not uncommon. In fact, statistics reveal that 52% of Americans have withdrawn from their retirement money early and 23% specifically did so to pay off their debts. While it may seem like a logical step to take, consider the following effects of prematurely withdrawing from your retirement funds.
Early withdrawal penalties
Although it is your money, it is generally discouraged to get from it until you are ready to retire. This is why there are penalties when you withdraw before the age of 59½. As of 2014, the penalty is 10%. So if you plan to withdraw $5,000, you need to pay a penalty of $500. That is a huge amount of money that will be wasted just because you decided to get your money early – even if it is to pay off debt. Of course, there are exceptions – like if it is for tax debts or something serious like medical expenses, and you are unemployed. If you qualify and you have the right retirement account, then you might not be required to pay the penalty. But if it is to consolidate debts, then it is not exempted.
Another effect of withdrawing from your retirement fund early involves tax deductions. This is only true for both 401(k) or IRA accounts. If you have a Roth account, you do not have to pay taxes because it was paid for already when the contribution was made. But traditional accounts like the former 2 that was mentioned will have tax deductions. This will depend on your income tax rate. That means the tax deduction is between 10% and 39.6%. This is for federal taxes only. Most of the time, the state will also get involved and take their own taxes.
Finally, withdrawing from your retirement fund early would mean the amount will be missing out on the benefits of compound interest. This refers to the interest that is added to your money and any interest that accumulated from the previous month. It makes your money grow faster because of the “interest on interest” concept. This is the reason why everyone is encouraged to save up for retirement early. When you take your money out, the interest you will earn for that particular month will go down because you have a lesser amount. Even if you put back the money as soon as you can, you might not be able to get that back. It would be hard to maximize the benefits of the compound interest especially if you have to save for retirement and consolidate debt at the same time.
Alternatives to using retirement fund to consolidate debt
Now that you know the effects of withdrawing from your retirement fund early you will probably think twice before using it to consolidate debts. But the question remains – what can you do to consolidate debts if you cannot use your retirement savings?
Here are three options that you can look into.
Debt consolidation loan
This option involves borrowing a loan that will pay off your debts. There are people who think this is not a good option because you are basically using another debt to pay off your existing debts. While this is technically true, it does have a lot of benefits. A debt consolidation loan offers a lower interest rate compared to credit cards. So if you have mostly credit card debts, it will help bring your overall payments down. And if you have a good credit score, this interest rate will even be lower. The money you can save here could be used to add more to your retirement fund.
Another option is to use a balance transfer card. This is basically a new credit card that offers 0% interest on the balance that will be transferred. Some offer it with a very low-interest rate – but that usually means the transfer fee will be waived. This is only for a limited time so the key to make balance transfer successful is to pay as much as you can each month. Ideally, you want to pay off the whole balance by the time the low rate expires. This is how you can maximize the benefits of having a 0% interest. Once the promo rate ends, the balance transfer card will have a higher interest rate.
The last option is debt settlement. This option is good for those who need a debt reduction so they can contribute more towards their retirement fund. This option involves negotiating with creditors and lenders so they will allow you to pay only a portion of what you owe. After making the payment, the rest of the debt will be forgiven. Admittedly, this can feel like an intimidating negotiation process to go through. This is why some people opt to use the help of a professional. But if you know your rights and what is involved, you might be able to work on this on your own.