Should You Tap Into Savings To Pay Off Debt?
Many workers are tempted to withdraw money from their retirement accounts when holding debt they want to pay down. Others cash out their retirement funds when changing jobs, rather than rolling over their 401(k)s into an IRA or other type of savings account. While the move may seem like a tempting one, some experts and financial advisors say it's not necessarily advisable. One reason is that withdrawing cash from a retirement account comes with a 10% penalty for early withdrawal, and other fees and taxes may apply as well.
A report by the Employee Benefit Research Institute (EBRI) showed that while only 12.4% of respondents that held no debt withdrew their retirement savings when switching jobs, some 27.3% of people who owed between $3,000 and $10,000 opted to take cash out at that time. Overall, those workers saddled with increased levels of debt were less likely to rollover their retirement savings into an IRA when changing jobs. The report also showed that close to 28% of people with no debt went ahead and rolled their retirement savings into an IRA, while only about 11% of people with $10,000 or more in debt did so when leaving their jobs.
EBRI considered retirement data taken from 2008 and 2010 surveys, which asked workers how they handled their retirement plans after leaving their jobs. What it found was that savers' behavior varied not only according to their debt levels, but by their incomes as well. Lower earners were more likely to withdraw money from their savings; some 30% of people who made less than $25,000 a year cashed out their savings. By contrast, only about 10% of people who made more than $75,000 did so.
USING FUTURE INCOME TO PAY DOWN DEBT
Savers who choose to cash out of their retirement plans to pay off debt are kneecapping their retirement savings efforts. That’s because the amount they decide to withdraw will end up being a lot less once taxes and fees are paid.
For example, if a worker takes $16,000 out of his or her retirement account, that person could end up paying $3,200 in federal and state taxes, as well as $1,600 in penalties. So of that $16,000, only $11,200 would go back into their pocket. Additionally, that person would potentially miss out on the investment growth he or she could see if the money had remained invested. So it’s important for savers to weight the loss in potential growth of their investments. In a bullish market, the growth of their investments could potentially outpace the savings exacted from paying off debt.
WHEN RETURNS OUTPACE YOUR APR
To look at another example, if the same person pays off $10,000 in credit card debt at an interest rate of 15%, they may end up paying more than $5,000 in interest charges over 10 years after having made $200 in payments each month, according to calculations by Jack VanDerhei, research director at the EBRI. By investing that same amount in an investment portfolio the same person could almost double their assets over a 10-year period to about $19,600 when adjusted for inflation. The total amount of lost income growth would be about $4,600 and that does not even include the taxes and fees that would need to be paid for withdrawing the money.
That said, paying off debt could help a person catch up on savings that they could invest later. They could also improve their credit score by paying off debt, which may affect their ability to land a new job and take out a loan at a lower interest rate.
Age is another factor in how people react toward savings. A Vanguard study showed that workers in their 20s are more likely to withdraw money from their savings accounts than older people. Younger people tend to underestimate that saving just a small amount in a retirement fund can really add up over time if left to grow. Once they withdraw their savings they lose the advantages they have of having started to save early and benefiting from the compounding interest. They will then need to contribute more money to their accounts later on to catch up.
THE BOTTOM LINE
Workers should think twice about withdrawing retirement money to pay off debt. They should be sure to consider the taxes and penalties involved, as well as the lack of compounded interest growth on the money withdrawn.