Using retirement savings to pay off debt is tempting, but be careful
It can be comforting to watch retirement savings — whether an IRA or 401K — grow over the years, as the money that accrues will provide for needs and wants during retirement. But the balance in a retirement account may also be a tempting source of cash for those who need to pay down debt.
Using retirement savings to pay down debt could create issues for people getting closer to retirement, but there could also be scenarios in which it’s an idea worth entertaining, according to an article written by Ashley Kilroy for SmartAsset.
“Your retirement savings should probably be a last resort to meet your financial needs, for most people,” Kilroy wrote. “You could incur penalties and taxes to use your retirement savings to pay off debt. Plus, you’ll lose out on investment income, which can be impossible to recover in the future.”
Paying off certain kinds of debt may allow for the avoidance of penalties, however.
“Various circumstances allow you to withdraw money from a 401K or individual retirement account (IRA) before age 59.5 without getting hit with the 10% early withdrawal fee,” Kilroy wrote. “For example, if your unreimbursed medical debt is 10% or more of your adjusted gross income, you can withdraw from your retirement account penalty-free to repay the debt.”
Or, if your debt is to the IRS for taxes, early withdrawal penalties do not apply if the funds are used for those purposes. The penalty can also be avoided for those who are permanently disabled.
“In situations where you can avoid the early withdrawal penalty, a chief consideration is the returns your retirement account generates versus your debt’s interest rate,” the article states.
A 401K account can also be the source of a loan that is paid back with interest — which effectively replenishes the account.
Recent data indicates that retirement withdrawals have increased recently, and at least one reverse mortgage industry educator has seen the uptick as a potential upside for the industry.
“The baby boomers are aging into a bracket where they have required minimum distributions, and people are drawing more money because they have to,” Understanding Reverse author Dan Hultquist told RMD in December.
Home equity could be a potential path to opening a new “bucket” of savings, Hultquist said.
“In Atlanta [at the NRMLA Annual Meeting], Longbridge CEO Chris Mayer mentioned that when people feel like they can draw more money, they spend more money on things like medication. People tend to be afraid of drawing too much money from other sources, because it’s not sustainable. But once we open up a new bucket with something like a reverse mortgage, that can serve as a solution,” he said.