According to data collected by the Federal Reserve, the average American household holds $15,480 in debt. At the same time, over 77 million Americans, or 35 percent of adults with a credit file, have debt in collections, which could significantly impact their credit score.
With this looming debt, it’s not surprising that some people look to their savings accounts to solve their financial woes, says Nicole Mayer, a life transition specialist with RPG, a wealth management firm that provides resources to individuals going through life changes.
“They see this large sum of money sitting there, and they are in dire straits,” but retirement savings should be a last possible resort because of the tax penalties, Mayer says.
What’s the problem with using your retirement savings to pay off credit card debt?
This route usually tempts Mayer’s clients who are in their 40s and 50s. These clients may have saved up a substantial amount and are looking to erase their credit debt before retiring.
“It can be such a costly mistake to take money from your retirement funds,” Mayer warns. If you take money out of a retirement account, such as a 401(k), before you are 59 ½ years old, you will have to pay a 10 percent tax penalty on that money in addition to the ordinary income tax.
Taking money out of your retirement account could also bump you up to the next tax bracket, which could result in as much as a 40 percent tax increase.
“You’re saving that money for a reason—it’s not just sitting there doing nothing,” Mayer explains. By tapping it early, you will miss out on the benefits of compounding interest and may not have enough money on which to live once you retire.
What are your other options?
First, evaluate your spending to see if it’s possible to pay off credit accounts with your current income. Budgeting is much more difficult than taking a chunk of money from your retirement fund, but it will save you more in the long run.
If you have investment accounts outside your retirement accounts, using them might be a better option than raiding your retirement fund. “Some people forget that other investment accounts are better to take from because they are taxed differently,” Mayer explains.
Consolidating to a low-interest card may be another option, but be wary. Often, low interest cards are promotional opportunities that expire. Be sure to read the fine print—the last thing you want is more debt. If you are confused by the terms, consult a financial advisor or credit counselor.
“There are non-profit credit counseling services that will help you negotiate to a fixed lower rate and will actually work with you to make payments that are affordable to you,” Mayer says.
Some of Mayer’s clients have even chosen to downsize to an apartment and sell or rent out their home in order to earn extra income. It’s a smart way to utilize your assets without jeopardizing your future, Mayer says.
When it may be necessary to tap into your retirement savings
If you are on a solid savings track and have over $500,000 saved, taking out a few thousand dollars is not going to endanger your retirement. Also, if you are older than 59 ½, you won’t have to pay the 10 percent tax penalty (but the extra income could still boost you into the next tax bracket).
If you absolutely have to use your retirement savings, borrowing from your 401(k) will be your best bet because you will be paying the interest back to yourself and you’ll have up to five years to pay it back, Mayer says. Be sure to evaluate your budget and examine your spending first before you borrow from your retirement fund.
Ilyce Glink is the author of over a dozen books, including the bestselling 100 Questions Every First-Time Home Buyer Should Ask and Buy, Close, Move In! Her nationally syndicated column, “Real Estate Matters,” appears in newspapers from coast-to-coast, and her Expert Real Estate Tips YouTube channel has nearly 4 million views. She is the managing editor of the Equifax Finance Blog, publisher of ThinkGlink.com, and owner of digital communications agencyThink Glink Media. In addition to her WSB radio show and WGN radio contributions, she is also a frequent guest on National Public Radio. Ilyce is a frequent contributor to Yahoo and CBS News.
The information contained in this blog post is designed to generally educate and inform visitors to the Equifax Finance Blog. The blog posts do not give, and should not be assumed to provide, personalized tax, investment, real estate, legal, retirement, credit, personal financial, or other professional advice. Before making any financial decision, you should always consult with the appropriate professionals who can explain your options, rights, and legal responsibilities, and advise you on any tax, legal, credit, or business implications that may result from those decisions. The views and opinions expressed by the authors of blog posts are their own views and may not be the views or opinions of Equifax, Inc. and/or its affiliates.