Should You Use Retirement Savings to Pay Off Debt?

by Kevin on January 28, 2013

Are there times when you should consider using some of your retirement savings to pay off your debt? Liquidating retirement assets should never be taken lightly, but I do think there are times when doing so is the right course.

Here are a few.

Survival vs. Retirement

If your survival is at stake, this is probably as good a reason as any to consider liquidating retirement assets. If, for example, a prolonged period of unemployment, or a business failure left you unable to make payments on your car—which you need to get a new job—then using retirement assets to pay off the car loan would be a survival issue.

Not all debt payoff situations are true survival issues, so this is an area where you have to be careful. Liquidating retirement assets to prevent a foreclosure of your home, for example, can be a case of throwing good money after bad if you haven’t first addressed the causes that led to the default situation in the first place.

Health considerations

Have you ever seen a situation like this? Someone with $30,000, $40,000, maybe $50,000 in credit card debt in mental and physical anguish over how he or she will payoff the debt—all while having a 401K or IRA with a high five or low six figure balance.

I don’t know about you, but I’ve known a few people in this situation. From where I sit, the answer is easy, if you just connect the dots. Large debts causing you anxiety and lost sleep, while an even larger base of funds exists to make the debt go away.

I don’t care what the financial planners say, or how many say it, preserving a retirement account or any other asset at the expense of your health is never worth it. Follow their advice and you might not live long enough to enjoy the benefits of your retirement plan.

The unkindest cut of all

I’m going to say something here that many will never utter in the same sentence with “retirement planning”. Stock market crash! There I said it. And it needs to be said when a large retirement plan co-exists along side of large debt. Here’s why.

A stock market crash can come along and crush your retirement plan. It doesn’t matter if it’s a steady multi-year decline, or an old fashioned, bottom-falling-out-of-the-market type of crash, it can drop the value of your retirement plan by 30%, 40%, 50% or more. And it can do it before you become aware that you might want to sell some holdings to limit the damage.

And you know what it will do to your debts? Nothing! They’ll be just as large as they were before the crash.

This is a nightmare scenario; your debts sit there while the value of your retirement plan takes a big haircut. Any chance that you could use at least some of your retirement money to lighten your debt burden will be lost. This is the hidden risk of having both large debts and large retirement assets.

Tax considerations

In addition to the fact that tapping retirement money to pay off debt could leave you inadequately prepared for retirement, the biggest issue is the tax consequences that result from liquidating a plan.

Not only do you have to add the amount of the distribution from your plan to your income when you file tax returns for the year of distribution, but you also have to pay a 10% penalty tax if you do so before you turn 59 ½. There are some exceptions on the penalty tax, but you will still have to pay regular income tax on the distribution even if you qualify for one of the exceptions.

From a pure tax standpoint, the best time to liquidate retirement assets to payoff debt (or any other reason) is during a year when your income will be extremely low. There will be a huge and obvious difference in liquidating retirement assets when your marginal tax rate is in the 10-15% range compared to 28-35%. Typically however, the need to tap retirement savings is greatest in years when income is lowest, so the tax considerations are minimized.

What do you think about liquidating retirement assets to pay off debt? Are there times when you think it’s justified? Or do you think that retirement assets should be preserved for retirement only?

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