Withdrawal From 401k To Pay Off Debt – If you’re in the process of paying off credit cards, car loans, or student loans, you know that every extra dollar of debt helps. But if you’re starting to think of your retirement fund as a way to dig yourself out of a hole, wait!
While it may be tempting, taking money out of an IRA to pay off debt is a terrible idea. Not only can that money come with outrageous early withdrawal penalties and taxes, but it also steals from you in the future. We’ve broken down what happens when you pay off your retirement fund early, and we’ll tell you how to pay off your debt without raiding your IRA.
Withdrawal From 401k To Pay Off Debt
Or you read every letter, an IRA (Individual Retirement Account) is a great tool for building wealth and ensuring a dignified retirement. But the key word here is
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. Dave Ramsey says you shouldn’t take money out of your IRA early unless it’s to avoid bankruptcy or foreclosure. Why? Because using your pension fund for anything other than a pension can incur high costs.
Money withdrawn from an IRA early (before age 59 1/2) must be rolled over to another retirement account within 60 days to be considered a “tax-free rollover.” We repeat: 60 days! Otherwise, the government will absorb its cuts in the form of fines and taxes. So if you’re withdrawing money from your 401(k) because you’re changing jobs and want to move it to a new company, make sure you do it within the 60-day period. That way, you won’t lose any of your savings. After all, it’s your hard-earned money and you deserve to keep as much as possible. Also note that tax-free rollovers can only be made once every 12 months.
When those 60 days are up, the IRA money is considered paid out. And the penalties and taxes you’ll have to pay on that money depend on the type of retirement account it came from: a 401(k), traditional IRA, or Roth IRA.
Early withdrawals from a 401(k) come with a 10% penalty. You also have to pay tax on anything you take out, but the IRS usually automatically withholds 20%. And if you withdraw a significant amount, you could end up in a higher tax bracket as a result. So if you took $20,000 from your 401(k) and that puts you in the 22% tax bracket, you might only get about $12,000-$13,000 (depending on income taxes) when it’s all added up.
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And because 401(k)s are funded with pre-tax dollars, you’ll still have to pay taxes on anything you take out, even after age 59. But there are some exceptions to paying penalties for early 401(k) withdrawals, which we’ll discuss later.
But if you’re thinking about taking money out of your 401(k) to cover expenses or pay down debt, ask yourself: Do I really want to borrow money at 30% interest? Of course not! Sometimes you just need to do the math to figure out what you’d actually be losing.
Taking money out of a traditional IRA before 59 ½ also results in a 10% penalty. There’s no automatic withholding, but you’ll still have to pay federal and state income taxes on the amount you withheld when it comes time to file your taxes.
Like a 401(k), there are some exceptions to the early withdrawal penalty for traditional IRAs (we’ll get to that in a minute). But even if you can take money out of your IRA, that doesn’t mean you should. Instead of having to pay 30% to the government, you can make regular deposits into a savings account and use 100% of that money for expenses you know are coming, like helping your kids get into college or buying a house. Don’t steal from yourself just because it’s easy now.
Taxes On 401(k) Withdrawals & Contributions
Because a Roth IRA uses after-tax dollars but becomes tax-free (one of the reasons we love it so much), you can withdraw all of your contributions regardless of your age and without penalty or tax. But to withdraw income (also called compound interest growth), you must be at least 59 ½
The Roth IRA itself must be at least five years old. Otherwise, you must pay a 10% early withdrawal fee, plus all taxes.
But the whole point of investing in a Roth IRA is that you don’t have to pay taxes when you withdraw money in retirement. You’ve already paid tax on the money you put in, so why would you want to pay more by withdrawing too quickly? We think you should take full advantage of your Roth IRA—and the best way to do that is to leave it alone until retirement.
While you’ll still have to pay taxes on money withdrawn from a 401(k) or IRA before a certain age, there are some circumstances that allow you to avoid the 10% early withdrawal penalty for retirement funds.
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There is also an exception to the early retirement penalty for a 401(k) if you receive a “hardship distribution.” It’s money set aside from your 401(k) to meet an “immediate and dire financial need,” according to the IRS, and it can include things like repairing damage to your home after a natural disaster, covering the cost of a loved one’s funeral, or paying rent to avoid eviction. And you’re only allowed to withdraw the exact amount needed for those expenses.
But even as it gets easier to reach your 401(k), remember that you’re the one who will have to live off that money when you retire. So be careful what you call an emergency and save your 401(k) for later.
If you are in a situation where you need money in your IRA to avoid bankruptcy or foreclosure, connect with SmartVestor Pro.
Another mistake people make is taking out a 401(k) loan to pay off debt, but you end up paying yourself back with interest. Bach! And 401(k) loans can backfire quickly. If you lose your job, you must repay that loan within 60 days. If not, you’ll have to pay – you guessed it – a 10% penalty plus tax. But the truth is that you cannot borrow your debts, so you should avoid borrowing altogether.
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Have you ever heard the old saying, “Let the sleeping IRA lie”? Not? Just us? The purpose of pension funds is to ensure that you are taken care of after the income stops flowing. But too many people think of their retirement fund as their emergency fund. And the more money you withdraw now, the less you’ll have left for those beach vacations, golf games, retirement days for the grandkids you dream of.
When your IRA becomes an ATM, you lose all the money you would have earned with compound interest. Compound interest is your best friend, but only if you give it a chance to work. (Try our compound interest calculator to do the math for you.) That’s what we call free money for those who wait. It is not money for today; it’s money for tomorrow. You’re in it for the long haul and investing requires a fair amount of patience and self-control.
Let’s say you took $50,000 from your IRA to pay off your college debt. You could end up paying about $5,000 in penalties and another $15,000 in taxes, leaving you with just $30,000. This is not right! But if you leave that IRA alone, the original $50,000 invested with a 12% return over 20 years would be worth more than $544,000! And that’s if you don’t contribute anything on top of that. See? Being patient and leaving that money alone pays off immensely.
The long-term cost of robbing your retirement fund just isn’t worth it. Many people say they can make up for the loss by putting more money into their IRA later, but there are limits to how much you can contribute each year.
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We know you work hard, and the last thing you want is to work harder and longer because you haven’t saved enough for retirement. Don’t be like the 90% of millennials who took money out of their retirement account and regretted it.
Leave your IRA alone, and when it’s time to use it, you’ll be glad you did!
So if you don’t cash in your pension fund, how are you going to pay off your debt? We’re glad you asked! Here are some proven ways to get rid of debt that you won’t regret.
Taking control of your money starts with a written plan – a budget. And a budgeting tool like EveryDollar forces you to be more aware of the money you have now, rather than wondering where it went later. Putting every dollar to work also creates a solid emergency fund so you won’t be tempted to tap into your IRA when life throws your way.
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