Using Your 401(k) to Pay Off Debt?

Using Your 401(k) to Pay Off Debt?

March 12, 2024

Retirement accounts, like 401(k)’s, have a defined purpose and the federal tax code reflects that purpose. They are designed in order to financially prepare individuals for life after full-time work. Because of this, the IRS allows for certain tax benefits inside of retirement accounts such as tax deferral in a 401(k) or tax-free withdrawals in a Roth IRA. In exchange for these advantages the IRS also disincentivizes the use of those funds for anything other than retirement. The primary example of this is that withdrawals taken from a retirement account prior to age 59 ½ are typically penalized at a rate of at least 10% (in addition to any other income taxes that may apply). The tax advantages that the IRS offers by way of qualified retirement accounts are essentially given “guardrails” to ensure that they are used for their express purpose. These rules and guardrails should give the average individual pause when considering a withdrawal that does not fall under the normal parameters of “retirement”.

                That said, what if you find that you are in need of funds in order to pay off a loan? What if you have a tremendous amount of student loan debt at a high interest rate? What if you are within a few years of retirement and have a balance remaining on your mortgage? To put it simply, does it ever make sense to step outside the retirement account “guardrails” in order to accomplish another, worthy financial goal? In order to answer that question, we need to consider a few important details: Early withdrawal penalties, Federal and state income taxes, interest rates, and expected investment returns.

                Let’s use the example of someone struggling to pay off their student loan debt. In this example let’s assume that Todd is 30 years old and has done a good job of saving for retirement so far. In fact, he has been able to accumulate a balance of $25,000 in the first 10 years of his career. Todd is married and in the 12% Federal income tax bracket. However, due to a recent job change, cash is tight and the Todd’s $30,000 student loan debt is not making that situation any easier. Todd and his wife, Marisue, have decided to withdraw the total amount of their prior employer 401(k) plan in order to pay off a sizable chunk of their student loans.

The majority of 401(k) contributions are made pre-tax and Todd’s case is no exception. That means that upon withdrawing his 401(k) balance 12% will be withheld for Federal income taxes. An additional 4.25% will be withheld for state of Michigan income taxes. Since Todd is younger than 59 ½, he will also need to set aside an additional 10% of the withdrawal in order to pay the IRS early withdrawal penalty. Collectively, taxes and penalties will reduce Todd’s 401(k) withdrawal from $25,000 to $18,437.50. This will mean that after the withdrawal and subsequent payment towards his student loans, Todd will have $0 in investments and still owe a balance of $11,562.50 on his student loans. Perhaps Todd wonders if this is a good tradeoff? Maybe making the payment on his student loans helps with his immediate cash flow issues. Fair enough, but what saves Todd more money in the long run?

Let’s assume that Todd moves forward with his plan to pay off a part of his student loan debt. When he looks at his budget, he determines that he can now afford to invest $200/month in a Roth IRA. Assuming an average annual return of 8%, it would take Todd’s investments almost 9 years to reach his prior balance of $30,000. By this point, Todd will be almost 40 years old and have the same investment balance that he did when he was 30! Following this trend, Todd would have an account balance of about $410,400 when he retires at age 65.  This probably doesn’t sound too bad right? Depending on your lifestyle and where you live, a retirement balance north of $400k may be enough to retire on. However, what would happen if Todd didn’t move forward with his plan?

Now let’s assume that Todd takes one look at the taxes and penalties of an early withdrawal and decides that he would rather tighten up his budget than pay unnecessary taxes. However, he is definitely not able to make additional investments at this time or any time in the near future. If Todd were to simply leave his $30,000 investment in his 401(k) until he retires at age 65, he will have a balance of about $490,000 in his account (assuming an average annual return of 8%). That’s an estimated $80,000 more than if he withdrew the funds to pay off student loans and doesn’t require that he invest a single penny more! By contrast, Todd would have to contribute $84,000 over the course of his career from age 30 to retirement in order to reach $410,000 and an additional $4,900 in order to reach $490,000!

                Sometimes life circumstances require us to take actions that are not ideal and I certainly do not wish to shame anyone who finds themselves in such a situation. However, when given the choice, keeping your funds invested instead of pulling them out early to pay off debt should be a pretty obvious decision. This is yet another great example of the power of compounding returns and a reminder that time in the market is at least as important as how much you are investing and certainly more important than timing the market.

 

Here in Michigan, it looks like we might be headed towards some Spring weather. Of course, that could change pretty quickly in our fickle climate. Regardless, the beginning of March coupled with nicer weather on the horizon has me excited for one of my favorite annual traditions: March Madness! Today’s song of the week should get you ready for some college basketball action! Enjoy!

Song 

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal.  Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.