Withdrawing From 401 To Pay Off Debt
Withdrawing from your 401 retirement fund to pay off debt is almost never a good idea, Dunn said. Most economists would not advise the average consumer to cash in a 401k to pay off debt unless there were really unusual circumstances, she said.
Withdrawing money from your 401 comes with hefty penalties and tax payments. Usually, doing it costs you more money than its worth and damages your long-term financial stability.
What Are Your Goals
- Your financial priorities can and will change throughout your life, which may affect how you balance saving, investing, and paying back debt at a given time.
Your personal and financial goals and timelines matter when deciding how to allocate your money, and its okay to reprioritize as your goals change. Keep in mind, your budget isnt set in stone forever, and it should be refreshed as you work toward and accomplish your financial targets.
For example, if youre determined to buy a home in the next year, you may choose to zone in on saving for your down payment and new furniture for a few months, while only making the minimum payments on any outstanding loans. But once youve closed on your new house, you might take that money in your budget and reallocate it to beefing up your monthly student loan payment.
Adjusting your financial priorities is easy to do using our Online Savings Accounts buckets tool, which lets you easily save for multiple goals at once, keeps your savings organized, and gives you a quick visual snapshot of all your financial priorities in one place.
Should You Use A 401 To Pay Off Debt
Whether you should use a 401 to pay off debt depends on several factors. If you’re younger than age 59 1/2, any withdrawals will be subject to income taxes and an early withdrawal penalty. After age 59 1/2, you pay income taxes. You also lose all the potential interest those funds could earn. If you have high-interest debt , it might still make sense to use 401 funds to pay it off. A financial advisor can help you decide which option makes the most sense in light of your financial goals.
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How To Pay Off Debts
If youve decided to use your spare cash to pay off your debts, then the next question is how to go about it. If you have enough money to cover everything you owe, the answer is pretty simple: Just pay it off. However, if you dont have that much cash to spare, then you will need to prioritize.
Generally speaking, youll get out of debt faster if you start by paying off your debt with the highest interest rate first and working your way down from there. For example, if you have balances on two credit cards, one thats charging you 20% and the other charging 15%, tackle the 20% balance first.
In the case of credit card debt, you may also have another option: Transfer your balances to a card with a lower interest rate, then pay them off. Some balance transfer credit cards offer promotional periods of six to 18 months, when they charge 0% interest, which can help you pay your balance down faster since you wont be incurring additional interest. Investopedia publishes regularly updated ratings of the best balance transfer credit cards.
Still another option is a debt consolidation loan from a bank or other lender. The way that works is that you borrow enough money from the lender to pay off your other debts. Now you just have one debt to worry about, ideally with a lower interest rate than your prior debts. You can then use your extra money to begin paying off that loan. Investopedia also publishes ratings of the best debt consolidation loans.
Hurting Your Future Retirement
Lets say you decide to sell your retirement investments to pay off your credit card debt.
Mathematically, it might seem to make sense. After all, you might be giving up an investment with an expected 5 or 10 percent return to pay down debt costing you 20 percent or more.
However, youll also have to factor in how removing those investments from your retirement plan can be equally devastating.
Lets say you have $20,000 in your retirement accounts, $20,000 in credit card debt, and that youre 25 years old.
If you plan to retire at age 65, that means you have 40 years for your investments to grow.
Further, lets assume you could earn a 10 percent return on those investments, which is the average U.S. stock market return over the long haul.
That means that by age 65, your $20,000 would grow to $905,185.
However, if you take that money out at age 25 to pay off debt, youll have to start from scratch again.
If it takes you 5 years to replace that $20,000, youll only have 35 years for that money to grow.
At the same 10 percent annual return, your $20,000 would only grow to $562,048.
That means that at retirement youd have about $340,000 less than if you had left the money in your account starting at age 25!
Thats a pretty big deficit. Certainly, its a lot larger than the $20,000 in credit card debt you paid off at age 25.
Of course, playing with numbers like this can be tricky.
But there are ways that you can have your cake and eat it, too.
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Is Cashing In Investments To Pay Off Debt Financially Stupid
This article was published more than 6 years ago. Some information may no longer be current.
You cant stuff massive amounts of debt into our household budgets without something giving way.Fuse
Heading into retirement laden with debt isn’t a comforting thought, but there are plenty of Canadians who are in, or inching toward, their golden years owing money.
Nearly 60 per cent of retired Canadians hold some form of debt, a 2012 CIBC poll found. And, when no longer earning an income, paying off debt can be a strain.
Here’s one strategy to clear the way for less stressful sunset years: Sell off some of your investments in your 50s and 60s and use the cash to pay down or eliminate debt.
But is it advised? That depends.
There’s no rule of thumb for this one, and financial experts say the decision to unload mutual funds or other assets to get rid of mortgage or credit-card debt is one that calls for careful consideration.
The move could make sense if the interest rate on the debt exceeds the expected return of the investment. However, this is often hard to answer, according to retirement and investment planner George Christison, founder of IFM Planning Services and the InvestingForMe website.
The theory pitting rate of return versus interest rate has other flaws, Mr. Christison says, because it ignores the investment costs, such as management expense ratios , total expense ratios , commissions, and asset fees, which are paid annually.
Type of debt
Pay Off Debt Or Invest 8 Factors You Should Consider
To pay back debt or invest. Thatâs the question. And itâs top of mind for many Canadians now more than ever.
Between historically-low interest rates, lockdowns driving a sharp decline in consumer spending, and online brokerages continuing to make investing easier, Canadians who are sitting on some extra cash are reevaluating their finances.
While you can invest and pay debt simultaneously, depending on the type of debt you owe, youâll want to prioritize more of your effort towards one over the other. Below are eight important factors to help you decide which path to take.
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Things You Need To Know About This Approach
I recognize that we are an extreme case, but I learned things I hope can benefit you, even if you cant pay off all your debt or pay it off as quickly. The advice to always be investing is well-meaning, but it can often ignore how much debt distracts us from becoming long-term, intentional investors. It also normalizes accepting debt as a perpetual part of life, when it doesnt have to be.
Even I underestimated how becoming debt-free can build the mental fortitude and discipline to become a better long-term investor, much like how running a mile at a time prepares you to run a marathon.
However, before you throw your retirement account to the wind to tackle debt, here are a few crucial pieces of advice, based on my own experience:
- Only pause investing if you are committed to a debt payoff plan for a finite period of time. This only worked for us because we paid off debt faster than most people would believe, and we stuck it out. If you cant pay off all your debt, try starting with the most stressful or pressing debt, like high-interest credit cards.
- Get organized on your plan before you pause investing.Streamline your accounts, automate where you can, get on a monthly budget, and build your plan before you stop your investing. And again, have a final goal for when youll be debt-free.
How Can You Best Manage Financial Stress
- Aim to manage your money in a way that limits your financial anxiety.
Your mental health and financial health are both extremely important, and oftentimes, the two can influence each other. When youre trying to decide whether you should prioritize eliminating debt, saving, or investing, think about which will give you the most peace of mind. If the thought of debt keeps you up at night, you may want to work on knocking that out first and foremost. Or if you are more concerned with your long-term finances, like your retirement fund, you might choose to invest some extra cash in your IRA each month.
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Be Careful About Withdrawing From Retirement Accounts To Pay Down Debt
Making withdrawals from IRAs, 401s, or similar employer-sponsored accounts to pay down debt is a risky proposition.
For example, if you leave your job, the money you borrowed from your 401 could quickly come due, leaving you in a situation where you might feel stuck in your job. Woodruff-Santos said you have to hedge the risk of needing to pay back the money quickly with the benefit of not depleting cash reserves you might need for emergencies.
“It is exceedingly rare where I would suggest or be OK with withdrawing from any investing account to pay off debt,” Matthews said.
He posed several questions you should consider before taking a loan from your retirement account to pay down debt:
- What is the debt?
- Is this something that is recurring?
- Is it something that it’s a one time thing and we’re done with it forever?
- How much is it?
- Do we have to pay this for x amount of time?
- Do you want to stay at your job for the foreseeable future, depending on when you’re looking at paying the loan off?
- Are there other ways to take care of that debt?
Be sure to consult a financial planner before deciding to take out any loans from retirement accounts to pay off debt.
Investing For Retirement Always Has A Place
While tackling bad high-interest debt â like credit cards or pay-day loans â should always be the priority, thereâs also plenty of grey area and you should strive to both pay debt and invest to at least some degree.
For instance, if you do owe a high-interest car loan, continuing to set aside a small amount of money towards retirement can be a good move. This way, you can allocate most of your money towards crushing your debt while still contributing a small amount towards your retirement bucket. Meanwhile, if your employer offers a Group RRSP plan with matching, simultaneously investing while also paying down your student loans can be a prudent decision considering youâre effectively getting âfree moneyâ to invest and could potentially end up with a bigger tax refund.
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The Critical Role Of Interest Rates
Good and bad debt aside, the interest rate on the loan you owe is hugely important too. The higher the interest rate, the more expensive the debt, and the bigger the priority should be to pay it off versus invest.
Interest rates on personal loans and unsecured debt can vary anywhere from 2% up to 20.99%, or higher. As a general rule of thumb, you should almost focus on putting most of your cash towards paying down high interest debt when rates start hovering close to the double digits.
A popular and effective strategy to speed up your involves using a balance transfer to move your existing balance from a high-interest card to a lower interest alternative. When paying for new purchases, itâs also always best to stick to a budget and pay off your monthly credit card balance in full to avoid owing any interest at all. And if achieving that is tough, consider sticking to a low interest card .
When a loan carries a low interest rate , itâs considered cheap debt and thereâs an argument for investing instead of paying off the debt immediately. The idea being, with such low rates, you can earn higher returns investing than youâll owe in interest.
How Much Is Your Debt
Consider how much debt you have and the interest rate. If you have high interest rate credit card debt or high interest rate student loan debt, for example, it makes sense to pay that off before saving or investing the bulk of your extra funds. Why? Those interest rates are likely much higher than you would get by investing the money. Making a plan to pay off that high debt as quickly as possible gives you more financial freedom.
If your debt has a low interest rate, for example a car loan, government student loans or a mortgage, it may make sense to continue making those regular payments each month and budgeting for them. Also, some interest, like a mortgage, may be tax deductible, so there are other advantages to paying back that debt more slowly. The interest rate you may receive from investing in a mutual fund or stock might be higher than the interest rates youre paying on these types of debts, so youll come out ahead in the long run.
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Should You Sell Off Investments To Pay Credit Card Debt
There are no two ways about it — credit card debt is a killer.
Many credit cards charge 20 percent, 25 percent, or even more. If youve triggered a penalty APR, due to a late payment, for example, you might have a rate as high as 29.99 percent.
The average American household had $6,354 in credit card debt at the end of 2017, according to Experian.
At 25% APR, that $6,354 would grow to a staggering $77,341 over 10 years if you didnt make any payments — or end up in court. And thats without making any additional purchases.
Needless to say, that kind of rapid debt accumulation can wipe out any household financial plan.
So, if youve got investments that can pay off your debt, is it worth it to sell them to pay down your credit card debt?
Its a bit of a double-edged sword. Yes, paying off credit card debt, especially at exorbitant interest rates, is important.
But, isnt saving for retirement and a sound financial future equally important?
Yes, without a doubt.
To figure out the answer for your personal financial situation, youll have to do some analysis — and some math.
Heres a guide to help you get started.
First Create An Emergency Fund
Though you may want to pay your debts as soon as possible, its important to prioritize emergency savingseven a small amountthat you can use in case an unexpected expense arises. A sudden ER visit or a spouse losing their job can throw a significant wrench into your financial plan. Without designated savings to pull from during such a crisis, you may feel the need to rely on high-interest credit cards or personal loans to cover sudden costs. However, doing so will only compound your debt and make the overall problem worse.
Its generally a good idea to have six months worth of expenses saved in an emergency fund, but this may not be realistic if you are also dealing with debt or otherwise struggling financially. If youre having difficulty saving at the recommended level, aim to save three months worth of expenses instead. Having at least some money set aside for emergencies is better than nothing, and you can always focus on building savings again once youve lowered your debt.
As you begin putting away money for an emergency fund, open a high-interest savings account so your money can grow when you pivot to focus on paying down your debt. While you continue to build your emergency fund, its also important to make at least the minimum payments on your debts to prevent late fees and potential damage to your credit scores.
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What About Low Cost Debts
Low or 0% interest deals can be a fantastic tool for managing your money. When youre financially disciplined enough to pay off the amount you owe during the low- or interest-free period, they can free up your cash flow and give you valuable breathing space.
So if the returns youre expecting to make by investing are greater than the interest on your debt, could it make sense to invest instead of paying off your debts early? Well, maybe in theory. But heres the thing.
Even if the interest rate for your debt is below 3%, theres no guarantee that you will be able to beat that in the markets. Remember, investments returns are only expected not guaranteed. And what if the stock market took a tumble? Then you could have losses as well as debts.
Another factor to consider is that paying a loan off ahead of schedule is not always cost-effective as there may be early repayment penalties.
One thing thats certain is your debt, whether interest-bearing or not, is a commitment that you need to be able to fulfil. Its on your credit rating as a liability. The last thing we want is for you to invest if it puts you at risk of not being able to pay off your debts.