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Never Pull From Your Retirement Accounts When Repaying Debt

As people generally remained at home and spent less money during the pandemic, American credit card debt declined. But as the world revived again, revolving debt increased between October 2021 and March 2022.  Credit card spending increased with a volatile stock market and record inflation levels over the past year. Many are examining available options to reduce credit card debts. Financial experts confirm that pulling funds from retirement accounts to repay credit card debt, is a poor option and other alternatives should be considered.

Downsides to Reducing Your Retirement Accounts

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Due to very high interest on credit cards, your debt balance isn’t reducing appreciably by making minimum payment. While lump sum payments are more effective, you need funds that many people rarely have on hand and consumers may turn to money in their retirement accounts. Financial experts agree that it’s unwise to tap your retirement account to repay debt, even for high-interest debt like credit cards, due to a nasty tax bill and a penalty on top of taxes, which lands you in a tougher situation if you lack the liquidity to pay off debt. In a pre-tax retirement account like a traditional IRA or 401(k) plan, you pay income tax for any money withdrawn. Depending on annual income, tax rate ranges up to 37%, and is excessively steep, with an additional 10% penalty for early withdrawals. Thus, a significant portion of withdrawn funds ends up going to the IRS. This has a significant impact later when you are not working, and rely on those funds. Your retirement portfolio stops growing and compounding if you withdraw the money from retirement accounts. You may even have a shortfall during retirement.

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Withdrawing $10,000 from a retirement account may eliminate credit card debt but retaining that money in your retirement account and without adding a single dollar, at a conservative estimate of 8% annual return, it exceeds $100,000 after 30 years, due to compound interest. Not touching investments, makes sense.

The Rules on 401(k) Withdrawals

Credit card debt may be unmanageable, but more options are possible. A debt snowball or debt avalanche calculator to examine how quickly debt could be repaid by allocating some excess disposable income every month. Repaying debt with money from your 401(k) plan makes sense in some cases, but reducing retirement savings is avoidable by considering preferable alternatives as under: If you use money from your 401(k) plan before you turn 59.5, you will generally have to pay a 10% penalty in income tax, because of premature withdrawal. After age 59.5, you will only have to pay tax on traditional 401(k) and IRAs (withdrawals for the Roth versions are tax-free). There are alternatives to 401(k) withdrawals for paying back debt, including 401(k) loans. The rules that apply on withdrawing money from your 401(k) plan depends on your age, the kind of 401(k) you have, and what your particular plan allows, after five years.

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If you withdraw $45,000 from your 401(k) to pay off debt, a 10% ($4,500) early withdrawal penalty is imposed and you pay income tax on the $45,000. But if you’re single, and taxable income is $100,000, your $45,000 withdrawal is taxed at 24%, or $10,800. Thus your $45,000 withdrawal costs you $15,300 and leaves only $29,700 to reduce your debts.

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