I've been asked over the years if it is wise to tap one's 401(k) or other tax-deferred retirement accounts such as an IRA pay off debts. While every situation is different, my answer is generally an emphatic no. Here are some of the pitfalls.
1. Money withdrawn from a 401(k), IRA, or other tax-deferred retirement account is subject to income taxes on the total amount withdrawn. For example, 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 approximately $13,333.
If you are younger than 59½, you will incur a tax penalty of 10 percent on top of any other income tax liability for a distribution from a tax-deferred retirement account. That $10,000 withdrawal would now cost you on the order $3,500. This is a pretty expensive source of funds.
There are a few exceptions to the 10 percent penalty. If you are 55 and have separated from your employer you may be eligible to take penalty-free distributions from your 401(k). There are also exceptions for situations such as death and disability. This chart contains a list of the exceptions to the 10 percent early withdrawal penalty for 401(k)s, IRAs, and other tax-deferred retirement accounts. Before moving forward with any of these exceptions it would be best to consult with a qualified tax or financial advisor.
2. Some 401(k) plans have a loan feature, which is likely your best route if you absolutely need to tap one of your retirement accounts. There will be a limit as to how much of your account balance can be borrowed and the number of outstanding loans you can have at one time. Also be aware that if you leave the company before fully paying back the loan the unpaid amount might turn into a taxable distribution.
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.
Moreover there have been numerous studies showing that many Americans are behind where they should be in term of their retirement savings. Some say that a general lack of retirement readiness is an epidemic in the U.S.
In my opinion this is the biggest drawback to tapping your retirement accounts to pay off debt: Most of us aren't saving enough to retire as it is. To compound the problem just deepens the hole. While sometimes tapping your retirement accounts may be unavoidable, this should be the last resort source of funds for any purpose, and especially for paying down debt.
Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides financial planning and investment advice to individual clients, 401(k) plan sponsors and participants, foundations, and endowments. Roger is active on both Twitter (@rwohlner) and LinkedIn. Check out Roger's popular blog The Chicago Financial Planner where he writes about issues concerning financial planning, investments, and retirement plans.