This is a common question and one where financial coaches regularly disagree. Assuming the stock market (and thus your retirement account) isn’t something you can predict very well, the challenge really comes around two things:
- If you have a 401(k) and withdraw money before you’re 59 1/2 (with the exception of a few hardship situations), you’ll pay income tax on the money you cash out and you’ll pay a 10% IRS penalty.
- If you withdraw your cash from the market, you can’t experience the long-term growth expected through retirement investing.
The Two Sides
One side of the argument says, “I’d be taxed on that money no matter what, so we’re really only debating about a 10% penalty. My credit card interest rate is 21% so a 10% penalty is a good trade-off.”
The other side of the argument says, “I’m automatically losing 10% plus the taxes, and that’s a huge hit. But I’m also going to lose out on any investment gains in the market because my money won’t be in there any longer.”
I think cashing out your retirement or other “reserved savings” to get out of debt is a bad plan. Rather than just tell you that, let’s look at the math. If you cash out a 401k or similar retirement plan, you’ll immediately have to pay taxes on that income (on the Federal level, this means 15-28% for most folks), plus any state taxes you may have to pay (varies widely by state), plus that 10% early withdrawal penalty. Depending on your tax rate and the state you live in, this means you could easily lose up to 40% or more of what you withdraw in taxes and penalties. OUCH! So let’s say you have $50,000 in debt and $50,000 in a 401k. If you cash out the retirement, you may only have $31,000 (maybe less depending on your state tax rate) to show for it.
The bigger challenge to me is the choice of this overall prescription for treating your debt. It is much like those who believe in debt consolidation as a good solution to paying off bills: you may be getting a lower payment…but have you fixed the problem(s) that put you in debt in the first place? Many who get this temporary relief are only a few years before needing the relief again, only this time at a higher level. The issue is not paying off the debt – it is changing the behavior to stay out of debt.
There is also the legitimate concern that removing your retirement savings now will lessen your ability to retire later. If you’ve got $50,000 in that retirement account today and use it on debt, how long before you could build that money back up? How much investment increase did you miss out during that time period? Unless you can time the market just before a major drop, you’re missing out on a lot of potential gains (and if you can time the market, this discussion doesn’t apply because you’re an investing and money genius).
I would challenge you to tighten up your budget in some other way that would allow you to put a little extra on that smallest debt until it is gone, then keep on rolling with the “snowball” by putting all that money on your next largest debt, etc. In addition, maybe you could find some side things here and there to put extra money on those debts. I do financial counseling, woodworking, graphic design, web design or just about anything else someone will hire me to do to make extra money from time to time. You might be surprised at how much extra you could bring in by doing little projects here and there. Just commit that every bit of that income goes toward your debts and you’ll be screaming “I’M DEBT FREE” in no time!