Raid retirement fund to pay off debt? Bad idea

Question for the expert

Dear Credit Wise,
I have roughly $15,000 in credit card debt and roughly the same amount (after taxes and penalties) in a retirement account I no longer contribute to. I am unemployed (hence the new debt) and am actively seeking employment. My question is this: Even if I find a job tomorrow and started paying monthly payments, doesn't it make sense to just pay off the debt with my retirement money and start using the money from my new job to start saving again? -- Michael

Answer for the expert

Dear Michael,
I know it is tempting on the surface to do as you say and simply pay off your credit card debt with your retirement  funds. However, very rarely is this recommended. Let me tell you why.

Early withdrawals from retirement accounts that have been built using pretax dollars carry stiff penalties. Since you mentioned taxes and penalties, I am assuming that this is the case. So you know that right off the bat you will pay a 10 percent penalty. Then the total amount of your retirement account will be taxed at your current tax rate. So right away you are probably losing somewhere in the neighborhood of $2,500 to $3,000 and maybe more, to arrive at the "roughly" $15,000 you would have left.

However, the penalties and fees are only part of the cost. The worst of it would be the loss of compound interest. Retirement accounts build on themselves, using the magic that is compound interest. The longer money compounds, the faster it grows. It takes about 12 years for money growing at 6 percent interest to double; however, in 24 years it will be worth four times as much.

It is also important for you to know that your retirement account can be rolled into a new account at any time. If what you had is a 401(k) account, you might want to wait until you are employed again and then roll it into your new employer's account once you become eligible. You can also roll it into an IRA; both will preserve your money and your tax benefits. It can also stay where it is, preserving both as well.

Of course, when discussing compound interest the reverse is true when it comes to your credit card debt. In this case, compound interest is working against you and is the reason that minimum payments are designed to keep you in debt for a very long time. Paying minimum payments on a $15,000 debt could take you 15 or more years to pay off, depending on your interest rates.

Chances are you are paying more in credit card interest than you are receiving on your retirement account funds and that is the reason for your question. Nevertheless, I still believe you should leave your retirement account intact and earning money for your future. Instead, search for other ways to deal with your credit card debt.

Your first priority is to secure employment. When it comes to your expenses, you must prioritize your home expenses (rent or mortgage, utilities, insurance) and food and health costs (groceries, medicines) and any secured loans that would result in repossession if you don't pay them (such as car payments). Credit card payments, while important, are not a priority when you are in a crisis situation.

I would suggest you contact a reputable nonprofit credit counseling organization and find out what options you may have to repay your debt without losing your retirement funds. A certified credit counselor will work with you to create a reasonable budget and give you options for paying off your debt. One option may be a debt management plan that could reduce your interest rates and maybe your payments. Counseling is free, but a debt management plan may have minimal fees. Your counselor will also be able to supply you with information about other resources, including food and housing assistance, as well as referrals to help you in your job search. The best place to find an agency to work with is through the Association of Independent Consumer Credit Counseling Agencies or the National Foundation for Credit Counseling.

See related: Should you remove money from your retirement savings?, Make financial planning as easy as 50/20/30, Ways to pay off high-interest debt

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Updated: 01-22-2018