Using Retirement Savings To Pay Off Debts

April 8, 2020

Should You Use Retirement Savings to Pay Off Debt?

Using retirement savings to pay off debts is usually allowed by most 401k or IRA providers in an especially bad debt situation.  Is it wise to use retirement savings to pay off debts? The answer to this is usually “no.” It is generally a very bad idea to use retirement savings to pay off debts.

Retirement Savings Require Taxes and Penalties 

If you prematurely remove retirement funds from an IRA or 401k, you will usually face stiff taxes and penalties.  The tax amount will usually be the same as your normal tax bracket which might be 15-20% or higher. To make matters worse, you will likely face a 15% tax penalty or even greater.  This is essentially making it so that you could lose up to 40% of your account benefit just to taxes and penalties. This makes it excessively costly when attempting to pay off debt.   Even if you face lesser penalties, it will still be a very expensive and overall inefficient way of dealing with debt.

Retirement Savings Should Be Used for Retirement

Retirement savings are specifically designed to provide solid resources and easier living during retirement.  In most people’s retirement, economic resources are limited. The value of having solid retirement accounts cannot be overstated.  You will have much lower tax brackets and no penalties also if you wait until retirement. Retirement accounts were never designed for paying off debts: they were designed to provide an easier life after retirement.

Retirement Savings are Exempt in Bankruptcy

You should not use retirement savings to pay off debt unless it is absolutely necessary.  In support of this fact, the government has made most tax-exempt, tax-deferred accounts “exempt” in bankruptcy.  Exempt simply means “not counted” as an asset in bankruptcy. That means you get to keep the entire account even as you get rid of your debts in bankruptcy. 

Therefore, it would be much wiser to file a Chapter 7 or Chapter 13 bankruptcy case generally to deal with debts.   Depleting your retirement is generally a very short-term solution that will only create problems down the road. Instead, bankruptcy permanently eliminates or restructures your debts.  It is a powerful solution that will not drain your retirement resources in any way.

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