When you have a lot of high-interest credit card debt, it can be tempting to liquidate your assets and pay it off once and for all. But before you withdraw your dedicated retirement funds, you need to understand the costs.
Should you withdraw your retirement funds early?
Short answer — no! Longer, clearer answer — even if your credit card interest rates are higher than your tax rate, it’s almost never a good idea to withdraw your retirement savings early. Here’s a rundown of the types of retirement accounts you may have and the costs you’ll incur if you withdraw from them before retirement.
What are the different types of retirement accounts?
Before considering the costs of early withdrawal, it’s important to understand the difference between traditional and Roth accounts. Each is handled differently in case of early distribution.
A traditional retirement account is contributed to with pre-tax dollars. Contributions and earnings will be taxed when distributed.
A Roth retirement account is contributed to with taxed dollars. Contributions and earnings will be distributed tax-free.
You should also know the difference between the two main types of retirement accounts — 401(k) and IRA.
- A 401(k) is an employer-sponsored plan typically made up of funds chosen by your employer. If you have automatic contributions from your paycheck into a retirement account, you likely have a 401(k) plan. Many employers also offer a Roth option.
- An IRA, or individual retirement arrangement, isn’t employer-sponsored. You open it yourself and choose the funds that make it up. Traditional and Roth options are available for your IRA. If you need help opening an account, check out this NerdWallet article on how and where to open an IRA.
Normally, retirement accounts can’t be distributed until after the age of 59½. If you withdraw money early, you’ll have to pay taxes and penalties. You’ll also miss out on the biggest benefit of investing — future gains.
» MORE: How to pay off debt
How are my early distributions taxed?
When you withdraw money early from your 401(k) or IRA, you’ll be required to pay taxes. If you have a Roth account, the taxes have already been paid, so skip this step. If it’s a traditional account, you’ll be required to pay your normal income tax rate, which for 2014 ranges from 10% to 39.6%. Your state also will likely take its cut — check out this list of 2014 state tax rates.
What are the penalties assessed on early distributions?
Because retirement funds are meant to stay in your account long-term, you’ll be penalized if you withdraw money before age 59½. The penalty is a flat 10% of your distribution as of 2014.
You’ll likely have to pay this amount on a traditional account, though you may not have to pay it on a Roth account.
There are also some exceptions to the penalty on traditional accounts, including these:
- For IRAs: If you roll over funds to another retirement account; if you have a permanent disability; if you’re unemployed and need money to pay for health insurance premiums; if you paid for college expenses, bought a house (subject to limitations), paid for medical expenses in excess of 7.5% of adjusted gross income or paid off tax debts
- For 401(k)s: If you’re over the age of 55 when you left your job; if you paid for medical expenses in excess of 7.5% of adjusted gross income; if distributions are required by divorce decree
You can withdraw any contributions from your Roth account without paying taxes or penalties. However, if you want to withdraw earnings, penalties and taxes may be assessed. This depends on how long you’ve held the account and the purpose of the distribution. For more details, check out these Roth IRA withdrawal rules — and understand the same will apply for Roth 401(k)s.
Why should you be worried about future earnings?
If you haven’t yet been schooled on the magical unicorn that is compound interest, you’re missing out. Basically, the longer you keep your money invested, the more it will grow. So possibly the biggest expense you’ll incur if you choose to withdraw your retirement funds early is the loss of future earnings.
Let’s say you have $20,000 in your retirement account and you want to withdraw it to pay off credit card debt. Estimating a conservative annual return of 4%, if you leave this money alone, it will grow to $64,868 in 30 years. This means, you’ll be giving up $44,868 by withdrawing your funds early. And that’s before factoring in the taxes and penalties.
Even if your credit card interest rates exceed your tax rate, it isn’t a good idea to withdraw funds early, for the same reasons.
Before withdrawing retirement savings for any reason, make sure you’ve exhausted all other possible options — legal ones, of course. Barring extreme circumstances, you’re better off paying off credit card debt the long way. You can do this by boosting your income and sticking to a budget to free up more money for debt payments. It also may be a good idea to set up recurring payments on payday — you can’t spend money that’s not there!
Piggy bank image via Shutterstock