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A lot of people who want to get out of debt wonder if they should withdraw money from their 401(k), Roth IRA, or other retirement accounts in order to get out of debt faster. Many of those people seem to call into the Dave Ramsey show. Dave usually gives the correct answer (don't use retirement accounts to pay off debt) but he gives a seriously goofy reason why. It sounds like this:
That's going to cost you 24% in taxes plus the 10% penalty to do that. Would you borrow money at 34%? This is just like that.
Uh…no Dave. It's not like that at all. Paying taxes and penalties is a one time cost, there are no ongoing interest payments. It's very different from borrowing at 34%. (Your debt doubles in 2 years at 34% by the way.)
Six Great Reasons to Avoid Using Retirement Accounts to Pay Off Debt
At least he gets the answer right. Today we're going to talk about six good reasons why not raiding your accounts to pay off debt is the right answer.
# 1 The 10% Early Withdrawal Penalty
First and most obvious is the 10% penalty. Pulling money out of a retirement account before age 59 1/2 causes you to owe a penalty that you otherwise would not have to pay. Voluntarily paying a fee that otherwise would never have to be paid is stupid. It is for desperate people in desperate circumstances. Like you're trying to come up with ransom money in the next 72 hours. Otherwise, it's just dumb.
Of course, the truth is that you can often get money out of those retirement accounts before age 59 1/2 without paying that penalty. The loopholes/exceptions to this rule are so large you can drive a truck through them. Take a look:
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- Unreimbursed medical expenses
- Pay for medical insurance
- Disability
- Death/Inherited IRAs
- Qualified Higher Education Expenses
- A First Home
- IRS Levy
- Reservist Distribution
- Early Retirement (SEPP Rule)
Chances are pretty good that one of those is going to apply to you most of the time you're thinking about raiding retirement accounts.
# 2 Loss of the Tax Rate Arbitrage
One of the most significant benefits of investing in a tax-deferred retirement account is the arbitrage between the marginal tax rate you saved upon contributing and the marginal tax rate(s) you paid upon withdrawing. For most people, there will be a significant difference between those two.
When you pull money out during your peak earnings years, however, you've basically given that arbitrage benefit away. Maybe you put the money in at 32% and took it out at 32%. Seems dumb to pay at 32% when you could otherwise take that money out at 24% later. Or maybe even less. Take a look at this graphic from The White Coat Investor's Financial Boot Camp to see what I mean.
You normally fill the brackets when you withdraw money from retirement accounts. But in your peak earnings years, you've already filled those brackets with your salary. So the withdrawal is taxed at a very high interest rate.
# 3 Loss of the Tax-Advantaged Space Forever
My son, who got to engage in my third dream career (medicine, writing, digging big holes with big equipment) before I did.
The other big tax benefit of investing in a retirement account is the elimination of the tax drag that occurs in a taxable account. All those taxes due on capital gains, capital gains distributions, and dividends, even qualified ones, cause your money to grow more slowly. When you pull money out of your retirement account, that space is gone forever. You have forever altered your ratio of tax-protected to taxable investing space. It might even be better to take out a short term 401(k) loan (up to the lesser of $50K or 50% of the balance of each of your 401(k)s) than to do that.
# 4 Loss of the Asset-Protected Space Forever
Guess what else retirement accounts are great for? That's right, asset protection. In most states, your IRAs and 401(k)s are 100% protected from your creditors in the very rare event of an above policy limits judgment. When you pull money out of them you've lost that benefit on the money too.
# 5 Earn More
As a general rule, your retirement money is invested fairly aggressively. You probably expect returns of 5%, 8%, maybe even 10% from it over the long run. Your debts may be at rates lower than that. Sure, if you've stupidly racked up 29% credit card debt, you probably can't out invest that. But a 1.9% car loan, a 0% credit card loan, 5% student loans, or a 4% mortgage? There's a halfway decent chance you'll come out ahead of that, even on a risk-adjusted basis.
Don't get me wrong, I am debt-free and I generally think borrowing to invest is folly. I know most of the people who take out 1.9% car loans “because I can make more investing” don't actually invest the difference. But the math doesn't lie. Borrowing at 2% and earning at 8% is a winning strategy most of the time and there is no better place to gamble on that than in a tax-protected retirement account invested for the long term.
# 6 Your Behavior Got You Into This Mess
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People don't generally get into debt because they don't know how to do math. People don't get fat because they can't count calories. It's their behavior that trips them up. The main problem with raiding a retirement account to wipe out your debts is that it is an “easy fix.” It doesn't address the cause of the problem. The problem is your spending is out of control. The debt is just a symptom.
The solution to the problem is to get your spending under control by using a budget, getting your income up, and lowering your spending. Withdrawing retirement money to pay off debt is just treating it symptomatically.
Now I treat a lot of medical problems symptomatically, but that's only because I don't have a cure for those problems. That isn't the case here. There is a cure, even if you don't like it. The financial muscles you build paying off those debts will be the same ones that allow you to get your savings rate up high enough to later become financially independent.
There you go. Six great reasons not to raid your retirement accounts to pay off debt. And one bad one supplied by Dave Ramsey.
What do you think? Would you raid a retirement account to pay off debt? Why or why not? Comment below!
Can you clarify the early withdrawal penalty with a Roth IRA? My understanding was if the contributions have been in the rIRA for at least 5 years, you do not pay the 10% early withdrawal penalty on contributions (but you do on earnings).
If correct, how does that work in practice? Can you specify if the 10k you’re pulling out of your Vanguard rIRA is coming from contributions, earnings, or both? (And if so, how?)
The 10% penalty only applies to earnings. It applies to earnings taken out before 59 1/2 OR earnings taken out on money that has been in there less than 5 years.
https://www.nerdwallet.com/blog/investing/roth-ira-5-year-rules/
Very good post. Thanks. Also, good job tossing another zinger at Dave Ramsey for extra click bait. 😉
So here is one for you. Are you building a pool for your boat with that giant backhoe that your son is driving? As if the boat wasn’t enough of a sink hole for money. (I know…I added a pool for the kids 2 years ago).
Seriously though…a new cabin? A pool? If not how can I get on the list to drive one of those babies!?
Wasn’t meant to be a zinger, but Dave did inspire the post with that lousy reason I opened the post with.
Doing an actual withdrawal is foolish. Doing a 401(k) loan may not be, depending on your circumstances, as long as you are fully informed of the risks associated with it.
It always surprises me how frequently plan loans are misunderstood, esp as it pertains to the fear of “double taxation” (which doesn’t occur). The two biggest risks are the opportunity cost of it being out of the market – which is minimized by only taking loans which can be repaid in a couple months – and being callable (or taxable) on separating from your employer, about which one generally has some foresight.
For instance, I utilized a 401(k) loan as a “bridge loan” when I bought a new house before I could sell the old one so as to avoid a contingency purchase which sellers dislike. The biggest risk was a delayed sale on my old house which would keep the money out of the market longer (or I could have just gone house-hunting halfway across the country again and bought a different house).
Fortunately, the old house closed only 6 weeks after we closed on the new house, and the loan was paid off within 7 weeks of taking it. The interest was 2.75%, which essentially constitutes an after-tax 401(k) contribution and is far superior to losing it to a bank at higher rates (bridge loans are frequently 6-10%). Ironically, the market had actually taken a slight dip before it rallied again after I paid the loan back, so I in essence sold high and bought low.
So if one has a short closed-ended period of needing the loan which is before the anticipated separation from the plan’s sponsor, a 401(k) loan – or 403(b) or TSP loan – can be the “least bad” means of bridging those short gaps, with the only cost being missed gains from time out of the market.
I was more aggressive in my use of 401(k) loans, to accelerate my payoff of my student loans (back in the dark ages before student loan consolidation, so I was dealing with a ~7.8% blended interest rate). On a risk-adjusted basis, I didn’t think I could beat 7.8% in the market, and the 401(k) interest payments went to myself.
In hindsight, it didn’t work out well. Lost out on much more than 7.8% in appreciation. But I can say with confidence that despite that “benefit” of hindsight, if someone presented me with a sure-thing 7.8% return today, I would take that over investing it in the market any day. So I still think it was the right decision.
It’s also a far, FAR superior choice if any alternative being considered involves not fully funding the 401(k).
What people are talking about with the “double taxation” is that the money funding the interest payment is post-tax, and you will then be subject to OI rates on any appreciation stemming from the interest payment. This is viewed as worse than a taxable account since the second tax is OI instead of capital. Of course, this only matters if your distributions and other income sources have you in a meaningful tax bracket in retirement.
I agree that the double taxation is a myth for the most part. More details here:
https://www.whitecoatinvestor.com/401k-loans-are-not-an-investment/