Does An Early Withdrawal From IRA To Pay Debt Make Sense?

When you are facing a pile of debt that you just can’t seem to shake it can be tempting to look toward your retirement accounts as a way to escape.

Retirement is a long time off and your debt impacts your life now, so why not withdraw money from your nest egg accounts in order to straighten up your finances right now?

As tempting as it might be to use your retirement savings to pay off debt, it can be extremely expensive to do so.

You need to truly be in a desperate situation in order to justify all of the expenses that come with tapping your retirement accounts early.

The Immediate Cost of Withdrawing From Retirement Accounts Early to Pay Off Debt

There are two types of cost associated to withdrawing early from your retirement accounts. Let’s look at the immediate costs first.

When you create an early withdrawal from a retirement account you line up to pay both income tax and an early withdrawal penalty of 10%.

There are some exceptions to the early withdrawal rules like paying medical insurance premiums during a long period of unemployment.

Another option is to use the 72T rules to escape the penalty burden. The following examples assume you don’t qualify for any of the random exemptions.

We’ll also assume for each account that over the years you contributed $6,000, it grew $4,000 to $10,000 total, and you are now withdrawing the full $10,000.

We’ll also assume a 25% tax bracket. Let’s consider your withdrawal costs from a Roth, IRA or 401k.

Roth IRA Early Withdrawal Costs

The Roth IRA is a unique retirement saving vehicle because you have already paid taxes on your contributions. You shouldn’t have to pay taxes ever again, right?

Unfortunately that is only partially true if you withdraw early from the Roth IRA. Your contributions to a Roth IRA will never be taxed again so you can withdraw them at any time. (This is why some people get started with a Roth IRA since they can also use it as a quasi-emergency fund if needed.)

However, any earnings generated on top of those contributions would be subject to tax and penalties if withdrawn before age 59 and 1/2. Using our example $10,000 withdrawal, here’s what you would pay:

Initial Withdrawal: $10,000
Tax-Free Withdrawal: $6,000 contributions
Taxes: Regular 25% income tax on $4,000 earnings = $1,000
Early Withdrawal Penalty: A 10% early withdrawal penalty on $4,000 earnings = $400
Total Taxes and Penalty Paid: $1,400 (14%)
Net Withdrawal: $8,600

You end up with 86% of the initial withdrawal. If you had $10,000 in debt to pay off you would need to come up with an additional $1,400 to pay it off.

If you could find a way to only withdraw your $6,000 in contributions you wouldn’t pay any tax or penalty.

Looking for an alternative way to pay off credit card debt? Consider using a peer-to-peer lending service to slash your interest rates.

Traditional IRA Early Withdrawal Costs

The Traditional IRA has opposite tax treatment from the Roth IRA. You don’t pay taxes up front so that your money has time to grow before being hit with taxes.

Whether you are withdrawing early or during retirement, you’ll pay income tax on the full withdrawal.

Initial Withdrawal: $10,000
Tax-Free Withdrawal: $0
Taxes: Regular 25% income tax on $10,000 withdrawal = $2,500
Early Withdrawal Penalty: A 10% early withdrawal penalty on $10,000 earnings = $1,000
Total Taxes and Penalty Paid: $3,500 (35%)
Net Withdrawal: $6,500

You end up with just 65% of the withdrawal; a terrible price to pay to try and pay off some debt.

If you had $10,000 in debt you were trying to pay off you would need to come up with some significant cash in order to do so.

News Flash: Due to recent IRA Tax Law changes, it is now even more difficult to take short term loans from your IRA.

401k Early Withdrawal Costs

The Traditional 401k is just like the Traditional IRA in terms of early withdrawal penalties and income tax. (The only difference outside of that is your 401k is tied to your employment and has a higher annual contribution limit.)

Whether you are withdrawing early or during retirement, you’ll pay income tax on the full withdrawal.

Initial Withdrawal: $10,000
Tax-Free Withdrawal: $0
Taxes: Regular 25% income tax on $10,000 withdrawal = $2,500
Early Withdrawal Penalty: A 10% early withdrawal penalty on $10,000 earnings = $1,000
Total Taxes and Penalty Paid: $3,500 (35%)
Net Withdrawal: $6,500

Again, you’re taking a huge hit and paying a ton of money in taxes and penalties.

The Long Term Cost of Withdrawing From Retirement Accounts Early to Pay Off Debt

The early withdrawal penalty and income taxes you pay are just the beginning of the costs of using your retirement account to pay off debt. Those are immediate; now let’s look at the painful long term impact.

Growth of Funds for Retirement

If you withdraw money from your retirement account now it won’t grow along with the rest of your investments. The longer period of time it would have had to grow, the more painful the loss of investment growth is.

Here are two examples assuming a 7% annual growth rate.

Example 1: $10,000 Over 20 Years

If you withdrew $10,000 as in our above example that could have been invested for 20 years before retirement, you’re missing out on a lot of growth.

Over 20 years at 7% that $10,000 would have grown to about $38,700. That’s a loss of $28,700 in investment growth.

Example 2: $40,000 Over 10 Years

Likewise if you withdrew an even larger amount at $40,000 and only had 10 years until retirement, the pain is still significant.

$40,000 invested at 7% for 10 years would grow to about $78,690. That’s a loss of $38,690 in investment growth.

Alternatives to Raiding Your Retirement to Pay Off Debt

There has to be a better way. Paying early withdrawal penalties of 10% just doesn’t make sense.

Paying income tax, especially on Roth accounts, just doesn’t make sense. Here are three alternatives to consider.

Send Less Than You Earn

The risk of raiding your retirement to pay off your debt is it doesn’t fix the underlying problem. The reason you have debt is you spent more than you earned.

If you don’t change that habit now it doesn’t matter if you withdraw from your retirement accounts to pay off today’s debt because tomorrow you’ll have more debt.

If you repeat the cycle the next time there won’t be a retirement account to tap to bail you out. Fix the spending problem now, earn more income, or even better do both to truly fix your financial situation.

Sell Your Stuff

In a bind and need to pay off some debt? Sell the stuff you bought with that debt.

You might take a hit on the dollar value, but clean out your house and sell all of your unnecessary items in order to pay off debt.

Save your retirement accounts as the very last thing you look to touch.

Get a 401k Loan

Lastly, you could take a loan from your 401k plan instead of doing an early withdrawal.

There are risks here, too, (namely you losing your job and the full loan being due within 60 days), but any interest you pay is deposited into your 401k account.

It’s like giving yourself a loan and paying yourself the interest in return.

Have you ever raided your retirement in order to pay off debt? Were you ultimately happy with the decision?