Q&A: "Should I Borrow From My Retirement Funds To Pay Off Debt?"

Question: 

Should I borrow from my retirement funds to pay off debt? 

I have found myself in debt after a very bad work year and several unplanned and unexpected large expenses. I'm single, 50, and have some funds (only about $150,000) in retirement. Some of this I could "cash" out to pay off my debt of 25K. Is this a good idea as the interest is killing me! Or should I grind away at it slowly? I realize that the tax hit too might make this untenable. Thank you.

Answer: 

Very sorry about how things have unfolded financially for you. 

I rarely recommend someone withdraw retirement savings to pay off debt. The exception might be if they're truly in dire straights or already in retirement and need a multi-year restructuring of their financial picture. Here are a few thoughts:

1) You indicated the interest is killing you, but didn't indicate what level of rates you're paying. Is this high-interest credit card debt, something else, a combination? If you're paying an extremely high rate, then maybe your situation warrants a retirement plan withdrawal. 

2) If you're thinking of taking a loan from a 401(k) plan at work that's one thing, but if you're considering a withdrawal from your Traditional IRA that's another matter altogether.

You actually can't "borrow" funds from an IRA. With an IRA withdrawal ("distribution"), you'll not only need to claim that as income and pay taxes on it, but there'll also be a 10% federal penalty tax. As an example, if you're in a 25% marginal tax bracket, add the 10% federal penalty tax, and you'll need to withdraw about $38,460 (gross) to end up with $25,000 after taxes. And don't forget state income taxes (if any). Bad deal all around! 

If your money is in a 401(k) and the plan allows you to take a loan, you can do so (up to 50% of vested account balance) without paying taxes. But you'd have to pay back the loan over a period of five years. Then the questions are: (a) How does the 401(k) loan interest compare with the other interest on your debt? (b) How do the repayments impact your cash flow...can you handle it in a five-year period? and (c) Are you okay with having lost tax-sheltered growth by handling it this way?

3) If you pull retirement funds to pay down debt, how confident are you that you won't have yet another bad year? This could snowball and become an exercise in depleting your retirement portfolio to nothing. 

So, if it's your IRA, I think you'd be better served just grinding it out with ongoing debt reduction. If you're talking about borrowing from your 401(k), that might work out okay, especially if average annual investment returns in the financial markets over the next 7 to 10 years are abysmal (as I believe likely). But even with the 401(k), if you can avoid the loan, then probably all the better.

Finally, your situation underscores why it's so important to have an adequate "rainy day" fund for emergencies and unexpected expenses. So I'd encourage to work toward building that up at the same time you chip away at your debt. 

Hope that helps. All the best!