Paying off debt with retirement funds should be your last resort. During the pandemic, as individuals stayed home and spent less, credit card debt in the United States decreased. As the global economy began to recover, however, revolving debt began to rise in the second half of 2021 and early 2022.
With a turbulent stock market and record-high inflation over the past year, it’s simple to see why credit card use has increased. Many are curious about alternative methods for paying off credit cards.
Two financial experts discuss why using your retirement account to pay off credit card debt is generally not a smart idea and the alternatives you should explore.
There are disadvantages to using your retirement funds.
Due to the infamously high-interest rates on credit cards, it’s easy to feel as though your amount isn’t decreasing when you merely make the minimum payment. And while a single sum contribution might be far more effective, many individuals simply do not have the necessary funds. As a result, people may turn to the funds in their retirement accounts.
Even if you have high-interest debt like credit cards, financial experts generally agree that using your retirement savings to pay off debt is unwise.
Tapping into some retirement accounts early can leave you with a hefty tax bill and often a penalty on top of taxes, said Lauren Anastasio, a CFP and the Director of Financial Advice at Stash, a financial technology company. Anastasio states that this will put you in an even tougher situation if you lack the liquidity to pay off the debt without it.
First, presuming the money is in a pre-tax retirement account such as a regular IRA or 401(k), you would owe income taxes on any withdrawals. The tax rate might range from 10% to 37%, which may be too high, depending on your annual income.
In addition, because the funds in your retirement accounts are intended for retirement, early withdrawals are subject to a 10% penalty. Between taxes and penalties, a substantial part of your withdrawals will go directly to the IRS.
More significantly, it may have a major impact later in life when you are older, unemployed, and want that money, said Paramita Pal, head of US Bankcard at TD Bank. Once you remove funds from your retirement account, your portfolio will no longer grow or compound to build your retirement savings, and as a result, you may have a shortage throughout your retirement.
Think about this: Withdrawing $10,000 from a retirement account might erase your credit card debt in a single transaction; however, if you retain that money in your retirement account and do not add any additional funds, with a reasonable assumption of an 8% yearly return on the market. It will be worth more than $100,000 after 30 years due to compound interest. The pleasure of not touching your investments lies in this fact.
Options Other Than Utilizing Your Retirement Accounts
It is reasonable that many credit card users desire to retain their credit score and, as a result, may worry if they find themselves in debt during financial problems, Pal added. But rather than dipping into their savings for cash, investigate other options.
Using your surplus monthly income to pay down your debt is the first choice for addressing your credit card debt. This alternative will not have the same impact as a single sum payment, but your debt will reduce gradually and steadily. And employing a debt payback plan, such as the debt snowball or debt avalanche, can assist in accelerating the process.
Even if you wish to approach your debt more aggressively, you still have other alternatives.
An alternate method is to search for credit cards that provide substantial balance transfer perks, such as waiving debt transfer fees or not charging interest on the transferred amount for a lengthy period, Pal said.
These credit cards often provide 0% interest for 12 to 18 months, which means that all of your payments are applied to your main debt rather than interest. However, you must devise a strategy to repay the loan before the promotional APR expires; otherwise, you risk being saddled with a high-interest rate (and possibly even retroactive interest charges).
Debt consolidation loans are an alternative to withdrawing money from your retirement account. Technically, it’s a personal loan, which means it’s unsecured like your credit cards. However, you may pay off many credit cards and consolidate your debt into a single balance and monthly payment. And you may frequently negotiate a cheaper interest rate.
It may be tempting to utilize your retirement funds to pay off debt, particularly if there is a substantial amount, but experts warn against doing so. In addition to the possibility of incurring hefty taxes and penalties, you may also jeopardize your retirement by robbing your future self.
As you seek answers to your credit card debt, you must also address the underlying causes of your current condition. Occasionally, debt is inevitable, like in the case of a financial emergency. However, if accumulating credit card debt appears to be a recurring issue, try establishing a budget to reduce your spending in to reverse direction.
Establishing a budget and adhering to it is essential, said Pal. Several digital tools are available to assist customers in managing their expenditures and identifying areas in which they overspend and may make cuts.