You’re mired in debt and struggling to make payments. Meanwhile, you have a nice retirement savings plan (RSP) that is earning money.
Now you’re asking yourself: Should I use those retirement funds to pay off this huge debt burden?
To answer this question, follow these six steps:
1. Find out how much money you can withdraw or borrow from your RSP
If your employer is contributing money to your savings through a 401(k), then you cannot withdraw any of the principal deposited by the employer. You can withdraw the money you deposited, however.
In addition, many plans allow people to borrow money from a 401(k) tax free, and pay back that money (with interest) within five years.
If your savings reside in something other than a 401(k), you must find out if there are limits to the amount you can withdraw or borrow.
2. See if any penalties may occur by the RSP withdrawal or loan
In order to withdraw money without penalty, owners must be aged at least 59 and a half or meet the IRS’s standards of extreme hardship (such as being totally and permanently disabled or, perhaps being heavily indebted.)
Otherwise, withdrawals are taxed a 10 percent “early distribution” (early withdrawal) penalty. Non-401(k) savings plans may also have penalties for early withdrawal and may also permit loans.
3. Calculate how much income tax you must pay
If you have a Roth savings plan, you have already paid taxes on the money you deposited.
If you have a traditional retirement savings plan or 401(k), however, you will be taxed on the money you withdraw, and that tax will be due by the end of that year.
Note: The amount of money you withdraw will be added to that year’s income. As a result, you may enter a higher tax bracket, requiring you to pay a higher rate of income tax.
If you borrow money from a retirement savings plan, you likely will not have to pay income tax on it.
4. Compare the RSP interest rate to the debt account interest rate
The greater the difference between the two rates, the more likely that using RSP money to pay debt will be worth it. For instance, credit cards tend to have interest rates of around 18 to 20 percent, whereas a savings plan loan may have an interest rate of around 5 percent.
5. Calculate the interest you will not have to pay if you eliminate or reduce debt
This value is perhaps the most significant of all the values you calculate. A major burden of debt resides in the interest payments. Because of interest, you can end up paying a lender several times more money than you borrowed.
A benefit of paying down debt quickly is that interest has less time to accumulate; therefore, the total payment will be less than it would be if you left the money in the debt account to accrue more interest.
6. Compare withdrawal penalties and taxes with the amount of debt interest savings
Generally, people should not use retirement savings for anything other than retirement.
However, if withdrawal penalties, income-tax payments, and/or loan payments on the money removed from the RSP are less than the cost of the accruing debt interest, you have made a case for using savings to pay debt.
The bottom line
If the cost-benefit analysis leans away from paying debt with RSP savings, think of other ways to reduce debt. Get a debt consolidation loan at a lower interest rate, for example. You might also find a way to increase your income or reduce your expenses so that you can use more funds for debt repayment.