It is quite tempting to repay your debts once and for all. You might decide to take out a 300 dollar loan to cover your debts or you might think of using retirement funds to cover credit card costs. However, is using retirement funds always as good for covering debts as it seems at first glance?
Statistics show a $46 billion increase in credit card debts since the first quarter of 2022. It means that most Americans use the money they don’t have, which increases their debts. Withdrawal of retirement funds seems to be the easiest option, but requesting money before you reach a certain age, results in taxes and penalties.
Let’s find the hidden pitfalls of using your retirement savings! You’ll notice there’s no need to have an economic background or be a financial expert to carefully plan your budget. You’ll understand the types of accounts and additional loan plans you can use!
The Types of Retirement Accounts
First of all, traditional and Roth accounts are different in taxation. For example, the first one is contributed from pre-tax dollars; which automatically adds tax to your earnings. The Roth account, on the contrary, is created from tax dollars; making it tax-free at the final point.
There are two other main types of retirement accounts:
- A 401(k) is an employer-sponsored plan. It means that contributions to your retirement account are coming straight from a paycheck.
- An Individual Retirement Arrangement (IRA) is not the type of account to be sponsored by an employer. IRA has both traditional and Roth options available.
In most cases, retirement accounts can be distributed at the age of 591/2 years or older. It doesn’t mean you can’t take money earlier, but you’ll have to pay taxes and penalties. Plus, you’ll miss out on the very important benefit — future gains.
Moving On to Practical Examples
Your money is a great tool for balancing tradeoffs and achieving your goals. Starting from fundamentals (income and expenses), you’ll understand the assets you might use to ease the pressure of debt.
For example, you have a $15,000 debt on your credit card, and you decide to take out money from a retirement account. What are the actual costs of repayment, if you withdraw money from a 401(k) account?
$15,000 (the amount you take) – $1,500 (10% penalty for early withdrawal) – $3,000 (20% an estimated income tax) = $11,500 (an actual withdrawal).
As it can be seen, you’ll still have to find $4,500. Another reason to avoid borrowing retirement costs is that you can’t fully return the money without facing negative financial consequences.
The outcome? You’ll need to withdraw more money to cover the remaining debt; with all the taxes and penalties, you can’t get the same amount you requested.
Take Care of Future Earnings
The main reason you should treat a retirement account carefully is simple mathematics. Just think of it — how much you can save if not withdraw costs until after you’re 591/2 y.o.? The more you keep savings untouched, the more they grow. As a result, before withdrawing retirement savings for any reason, make sure you’ve exhausted all other possible options, including looking into various forms of debt relief.
Let’s assume, you have $20,000 in a retirement account; now, we’ll find out how much you can grow in 20 years.
$20,000 (a retirement balance) * 20 years * 6% (estimated growth rate) = $64,143 (an approximate balance)
Now, before taking out cash from your retirement savings, it’s time to weigh all the impacts. There are consequences you may recover from, while others can harm your financial stability. Year over year, you may be giving up substantial returns from savings, and, to understand that, you need to keep in mind the bigger picture.
Adjust Your Budget With a 401(k) Plan
Being cautious is key. That’s why you need to consider all possible options to repay the debt before using a retirement account. As a “last resort”, we recommend considering a 401(k) loan.
- What are the limitations?
Up to 50% of savings or $50,000 (whichever is less), in 12 months. Additionally, you have to check if a personal plan allows you to apply for a 401(k) loan.
- How much is the payback?
The period is five years after a lender approves your application, plus interest. If you decide to quit the job, you must repay the loan first.
- What are the taxes and penalties?
You’ll be charged with additional fees, only if violating the Terms & Conditions of a loan.
- Is there any damage to your budget?
The only damage is missing your chance to grow a solid amount of money. During a loan repayment period, you’re left without a chance to improve your financial well-being. Since the majority of your income covers the loan fees, you’ll not have a chance for savings.
Why You Shouldn’t Borrow From a Retirement Account
All things considered — borrowing from your retirement savings is not always a good option. If you have credit card debt, weigh your financial sources; use an additional income, or borrow from friends.
Withdrawing from a retirement account is a bad decision, rather than a good one. In the future, you could be missing out on compound earnings had the money stayed in your account. The annual growth might not seem like a million dollars, but if you calculate it from a 20-years perspective, it is enough for sustainable living.
Sometimes, you can apply for a retirement loan to save money. In a down market in which your retirement portfolio is taking a beating, it might make sense to use the cash to get rid of higher-interest debt.
As always — the decision is yours to make! If you need money for an emergency; or you simply don’t have other options, you may request some cash from a retirement account. You can also get assistance from a non-profit credit-counseling agency to keep money safe.