Should I Cash Out My 403b Account To Pay Off Debt?

Help a reader with this question:

I currently have a 403b with about $20k in it. I am planning on leaving my job late April and was previously planning on moving the money somewhere else. However, I owe a family member $15k for a car they bought me almost 5 years ago. I did not pay them back yet because we have been working on paying off all of our other debts (which we have paid them all off!), and the family member was not charging me interest or asking for the money back. So this $15k (and our mortgage) is the only thing holding us back from being debt free. Would it be wise to consider pulling the money out of the 403b when I leave my job, paying the taxes, and then giving my family member the money to pay off the debt? Then I was thinking about opening a Roth IRA with any remaining money since I think we can get down to owing the family member $10k by the time I leave my job.

Another factor which I need to look into is how my company has invested in my 403b. I am not fully vested since I will be about 7 months short of becoming fully vested so I am not sure if I will lose money from the 20k when I leave my job.

My Answer:

Regarding the 403b, I would NOT pull the money out of it to pay off the debt you owe the family member. The reason for this is because you will potentially pay a 35% penalty to withdraw the money early. The 403b will charge you a 10% penalty and then you’ll owe the IRS taxes on the withdrawal amount based on your current tax bracket which is probably 25%. So, would you borrow 15k at 35% interest to pay off the personal loan? No, I am sure you wouldn’t, so there’s no reason to use the money from the 403b.

When you leave the company, transfer the 403b money into a Roth IRA with a discount stock broker. I like Vanguard, Charles Schwab, and You want to do a DIRECT transfer. This is very important, because if they cut a check to you, you cash the check, and put the money into another account, the IRS could hit you for the taxes. You want the money to go straight from the 403b provider to the new brokerage account. Whoever you choose will have instructions on what to do for a direct transfer.

I commend you for wanting to get out of debt quickly, and I think you still can, but the family member obviously isn’t hurting from that loan, so contact him or her and tell them you’ll start sending them money on a monthly basis. Who knows, maybe after 6 months of sending them money, they’ll forgive you for the rest of the loan. But, you definitely owe the money, so you should start putting together a repayment plan as part of your monthly budget to get the loan paid off as quickly as possible.

  • Michael Harr @ TodayForward

    A couple of quick points. First off, this is sound advice. If you were able to repay other debts, then you’re on the right track and paying off the last $15k shouldn’t be a big deal.

    On the advice to do a direct transfer, this would technically be called a rollover and while it would be smart to put the money into a Roth IRA, this would trigger a significant tax, as the entire amount in the 403b would become taxable for the tax year in which the money came out of the 403b. If you choose to convert to a Roth, do it next year so you can spread the tax burden over 2011-12.

    Also, be careful about the provisions within the specific 403b plan that you are participating in. Many, MANY 403b plans have serious surrender charge as they are often sold as annuities. A surrender charge is imposed by the annuity provider (a life insurance company) and I’ve seen them well into the teens depending on how old the contract is.

    A quick recap:

    1. Determine if your 403b has surrender charges
    2. Decide if you want to roll it over into a traditional/rollover IRA or a Roth IRA. With the traditional/rollover IRA, there’s no taxes and no penalties, with the Roth IRA, you pay taxes, but no penalties
    3. If you do the Roth, postpone it until 2010.
    4. Invest it wisely

    On #4, it sounds like you may not have a large enough emergency fund, so you might want to keep the money in cash until you’re out of debt and have a significant amount in cash reserves. No need to add market ups and downs to your current situation or this brutal economy.

  • Britt (Your Roth IRA)

    That’s exceptionally good advice.

    The taxes and penalties make it unwise to cash out of the 403b. But compounding the problem is the lost opportunity cost of compounding those funds tax-free in a retirement account for the day when you really need it.

    As Michael Harr points out, you’ve already managed to pay off your other debts. Take the funds you’ve been using to pay those debts and direct them toward the $15,000. Since no interest is being charged, there’s no financial gain incurred by paying off the debt early. In fact, through taxes, penalties, and lost retirement planning years, it’s just the opposite. Rollover into a Roth IRA, and find a cheap index fund for your $20,000. Then, forget about it and focus on paying off your debt through hard work.

  • Dave68

    You need to pay your debt to the family member you have a moral obligation to do so regardless of how much taxes you have to pay! What you are doing is wrong and you are taking advantage of a family member who was nice enough to loan you the money @ 0%.

  • Bro_davemartin

    why do all the information on withdrawing money from a 403b or 401k assume you are in the 25% tax bracket? I am in the 15% tax bracket and have no state income tax, but want to avoid defaulting on loans (my wife lost her job, she recently took a lower paying job) my 403b after taxes and 10%penalty is efficient to pay off current debt, and keep us from having to default on our debt. We have already met with a debt counselor and have consolidated our debt with a lower interest rate – but we are still struggling, with no room to save any money so the next emergency expense will put us into crisis. We currently have about $700 in savings, but haven’t been able to contribute to it in over a year.

  • fireinthebelly

    I am a 42-year old teacher and have $4000 in a 403b that is managed poorly and expensively by a company that is on the “approved list of vendors” throughout my school district. I want desperately to move this rather paltry amount of money to another company, but have been told on several occasions that I am not allowed to do so unless I resign or retire. I lose 1.25% every year for “management fees” on top of the annual account fee of $75. Should I just cash out, take the 10% penalty and use what’s left to pay off debt, put down on the mortgage, or fix my car? I already have over $220,000 invested in a 457 and in Roth IRAs, plus my Ohio pension… that I pray is still there in 20 years.

  • Jacob Loveney

    While withdrawing money from your IRA is relatively simple, you are responsible for filing the withdrawal on your taxes. Whether or not you must pay taxes on the distribution depends on if the IRA was a traditional IRA or Roth IRA. You must file your taxes using form 1040.

  • frank

    I am an educator for the last 16 years. I work in one district for 10 years in which I was paying social security and also PERS retirement plan. When I transferred to another district, I was in a different retirement plan, STRS. Will I be able to claim money from both retirement plans as well as social security? Or could at least transfer money from the retirement plans? Help!!!!