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Should you ever withdraw money from your retirement plans in order to pay debt? As a general rule, it should be avoided at all costs. For one thing, retirement savings are for retirement. For another, there are tax consequences for withdrawing money from a tax sheltered retirement plan, and they can be steep. Not only will you have to pay the tax on the withdrawal, but there may be a 10% penalty added on top of that.
Before withdrawing money from retirement plans, all other possible alternatives should be attempted first:
Only when all of these efforts have been tried and proven insufficient should liquidation of retirement money even be considered, and then only in limited situations.
Debt payments are so high you can’t afford to pay for necessities
If you have so much debt that the payments to service it are leaving little money for basic survival, then you’re in a do-or-die situation that requires the use of all of your resources, including retirement plans.
The key here has to be that the amount of money you would withdraw from retirement will be sufficient to payoff the offending debt completely, not merely to continue making payments for a few more months. If it’s not possible to pay the debt completely, debt counseling or even bankruptcy may be better options. With many retirement plans and in certain states, retirement assets may be exempt from bankruptcy proceedings.
Debt payments are threatening your health
If debt payments are so high that your health is being affected, withdrawing retirement savings to get control of the situation may be necessary. Not only is your health critically important, but impairment can have a negative affect on your ability to earn a living, and that alone can cause your financial situation to get worse.
In addition, you’re making retirement provisions to provide income for retirement—it’s even more basic to be sure you’re around to collect it when the time comes.
You’ve exhausted all other resources in a financial crisis
In recent years many people have been experiencing prolonged financial crises—extended unemployment and foreclosures among them. After several years of dealing with major money issues, savings can be wiped out and even the ability to earn a living may be degraded. Many times just having a cash cushion available in liquid form is all it takes to jump start your post crisis life and even get your confidence back for a new career push.
A withdrawal of a few thousand dollars, or enough to cover living expenses for 3-4 months may provide the breathing room necessary to get a fresh start.
You have debt but no liquid assets
This is similar to the situation above, except that it might have been brought on by—dare we say it—financial mismanagement. No matter how it came about, if you’re trying to manage a large amount of debt with no cash cushion to back you up, you’re probably setting yourself up for even bigger financial problems—that may require larger retirement withdrawals—at a later date.
Once again, you want to have enough money to give yourself breathing room so you can get control of your finances. But you’ll need to have a plan to get your debts under control for the long haul, not just to get through a few more months. Sometimes paying off a single loan—like a car loan with a large monthly payment—will help move you toward a long term solution.
When retirement withdrawals shouldn’t be made
We’ve covered some situations in which it’s probably or definitely a good idea to liquidate retirement assets. But let’s take a look at a few that sound legitimate but probably aren’t.
Foreclosure. On the surface, liquidating retirement assets to save your home seems like a good idea, but in reality it can be a classic case of “throwing good money after bad”. This is because foreclosure is usually an income problem that won’t be solved by a temporary infusion of cash. In most cases, if income is insufficient to make the house payment, the home will be lost in spite of short term maneuvers.
Getting “caught up” on bills. This is an attempt to fix a long term debt problem with short term money. The debtor believes that all will be well if he/she can just get caught up with the pile of bills, but in reality it’s just another way of making a debt problem easier to live with without fixing it.
Starting a business. If you’re starting a new business, the last thing you want to do is empty your retirement plan early in the process—you may need it later if the venture is unsuccessful. Equally important is that you will need to maintain assets independent of the business; being self-employed will require a diversification between assets and income sources.
Can you think of any other circumstances when a retirement plan withdrawal is a good idea—or when it isn’t?