Many people fall into this type of situation – they experience financial setbacks that prevent them from keeping up with monthly debt payments, but they have enough money in a retirement account to pay a portion of the debts. Strongly consider the consequences of using your retirement money to settle your debt.
Consequences of Withdrawing from Retirement
Many retirement accounts charge a penalty if you withdraw money before you reach age 59 ½. The amount you withdraw typically must be included in your taxable income if the contribution was made pre-tax. That could increase your tax liability and may cause you to end up with a tax bill when you file next year’s tax return. You may also face an additional 10% tax penalty.
There are some exceptions to paying the early withdrawal penalty. For example, the penalty doesn’t apply if the distributions are equal to or less than your deductible medical expenses. Unfortunately, most of the exceptions don’t apply if you’re using the money to pay off your credit card debt.
Losing Retirement Money
Taking money from retirement to pay off debt can be bad in the same way that creating debt can be bad – you’re essentially borrowing from your future income. If you take money out of your retirement fund, not only are you sacrificing the money you’ve already contributed and interest you’ve already earned, you’re also giving up the interest you could earn in future years if you left the money in your retirement fund.
Consider Your Age
The closer you are to retirement, the more it probably hurts if you withdraw retirement money. Think about this: if you’re settling your debts because you can’t afford to make your monthly payments, then you probably won’t be able to replenish your retirement account after your debt is repaid.
When you’re younger, i.e. in your 20s and 30s, you have more time to save for retirement, and your retirement savings also has more time to earn interest. If you’re putting money in retirement each month, you could temporarily stop contributing and use that money to pay off and settle your debts.
Retirement Money is Safe in Bankruptcy
Money you have in a retirement fund is generally exempt from bankruptcy. That means the bankruptcy court can’t seize your 401(k), pension or IRA and use it to pay back your creditors if you decide to file bankruptcy. So you could file bankruptcy, get rid of your debt and keep your retirement savings rather than get rid of your debt and lose your retirement savings. Keep in mind if your current monthly income (as defined in chapter 7 of title 11 of the United States Code) is higher than the median income in your state, you cannot file Chapter 7 bankruptcy and you’d probably be forced to file Chapter 13 bankruptcy which requires you to complete a three- to five-year repayment plan.
Think long and hard about whether you should use your retirement funds to get rid of your debt. Once the money is spent, you’ve probably gotten rid of your creditors, but you’ve probably also lost savings that will be critical later on in life.