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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:
- Unreimbursed medical expenses
- Pay for medical insurance
- 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
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
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!