Raiding Your Retirement Nest Egg to Pay Off Debt

By Dawn Handschuh, Personal Finance Writer   

401k withdrawal penalties

As borrowers look for ways out of financial crises caused by credit cards or other bills, many seize on retirement savings as a quick fix.

After years of contributing to employer-sponsored retirement plans, you may have accumulated a pile of cash that's hard to ignore. But withdrawing the money to pay off debt carries stiff penalties and robs your future. Even borrowing and then repaying your own money carries risks.

Withdrawal from 401(k) loans

Many plans permit employees to borrow as much as $50,000. Your repayments, unlike contributions, are made with after-tax money and begin immediately. When you withdraw money at retirement, it'll be taxed again, so you'll be taxed twice on the loan amount.

If you leave your job before the loan's paid off, the balance is due upon termination or it's considered a distribution.

Distribution penalties of a 401(k) withdrawal

Because 401(k)s are retirement savings vehicles, the IRS discourages taxpayers from using these tax-deferred monies for other uses. Here's what'll be deducted from your distribution:

  • A 10% federal tax penalty if you're younger than 59.5 years old.
  • Federal income taxes (between 10% and 35%, depending on your tax bracket).
  • State income taxes (unless you live in one of the seven states that don't levy such a tax). Many state income taxes exceed 7%, even for middle-class tax brackets.1

Between the penalty and combined taxes, you could lose 50% of your investment right off the top. If that weren't enough, here are more reasons not to touch your 401(k):

  • By depleting your retirement savings now, you may never catch up and have to work beyond retirement age.
  • Reducing your 401(k) balance reduces the benefits of tax-free compounding interest, which helps your money grow faster.
  • 401(k) money is protected from creditors, even during bankruptcy.

If your debt was caused by a true emergency, consider a loan or withdrawal from your 401(k) only as an absolute last resort.

But if your problem was overspending, using your 401(k) to pay off debt without making real changes in your spending behavior may be just a temporary stopgap to continuing debt. So treat your 401(k) as off-limits until retirement.

Footnote

1 State Individual Income Tax Rates, 2008, The Tax Foundation