It’s hard to get ahead in life when you have thousands of dollars in debt hanging around your neck.
Yes, it’s expensive, and yes, it keeps you up at night, among dozens of other reasons to get out of debt. But it also diverts your money and attention from investing and building wealth. While your peers pump cash into retirement accounts, real estate investments, and exchange-traded and mutual funds, you’re stuck paying down debt.
That leaves many borrowers wondering if they should raid their retirement savings to rid themselves of their debt once and for all and start from a clean slate.
The answer depends on your debt and your retirement accounts. It can sometimes make sense — but just as often, it costs more than the interest you already owe.
Before you make the decision, there’s a lot to know about retirement funds and debt to help you pay down your debt as quickly and cheaply as possible.
Tax Penalties for Early Withdrawals
When you take an early distribution from your retirement account, it usually comes with a nasty penalty from the IRS.
Usually, but not always. Before deciding whether to tap into a retirement account, you first need to understand the different penalties assessed for different types of accounts.
An individual retirement account (IRA) lets you invest money for retirement tax-free. You don’t pay taxes on the money you contribute to the account each year, but you do eventually pay income taxes on the earnings from those contributions when you withdraw money in retirement.
If you’re under 59-1/2 and you make an early withdrawal from your IRA, you must pay those income taxes you avoided when first contributing. Then, the IRS hits you with a 10% penalty to slap your wrist even harder.
In other words, if you’re in the 25% income tax bracket, it would cost you 35% in taxes and fees to withdraw money from your IRA. Would you borrow money at a 35% annual percentage rate (APR) to pay off your existing debt? Probably not unless your existing debt is with the mob.
There are a few IRS exemptions for special uses of early withdrawals, including specific health costs and health insurance premiums while in retirement. But you still owe taxes on the withdrawals, making even these exemptions unattractive for combining with debt repayment.
Read more about early withdrawal penalties and exemptions if you still want to explore that route.
401(k)s, 403(b)s, & Similar Employer-Sponsored Retirement Accounts
The early withdrawal penalties for 401(k) accounts, 403(b) accounts, and related employer-sponsored retirement accounts are similar to those for IRAs. When you pull out money early, you pay income taxes on the withdrawals, plus a 10% penalty.
If you’re allowed to pull it out early at all, that is. Unlike with IRAs, 401(k) administrators don’t always allow nonqualified distributions without meeting an exemption.
The IRS exemption list for these accounts differs slightly from the list for IRAs, so double-check it if you’re exploring it. But again, you owe back taxes even when avoiding the 10% penalty, rendering this option unattractive at best and often downright counterproductive.
The rules are different for Roth IRAs, making them a far more feasible option.
You pay standard income taxes on contributions to your Roth IRA, but the money grows tax-free once invested in the account. Since you already paid taxes on the money you contributed, you can withdraw it at any time, penalty-free.
Granted, when you pull money back out of your Roth IRA, it stops growing and compounding tax-free. You lose out on all that potential growth.
But if you’re paying 25% interest on $10,000 in credit card debt and only expect to earn an average return of 8% on your Roth IRA investments, then it makes more sense to pay off the debt than to keep the investments.
Bear in mind that you can only withdraw your contributions penalty-free, not the earnings on those contributions. If you invested $9,000 in your Roth IRA, and it’s now worth $10,000, then you’d owe income taxes plus the 10% penalty on any money you withdraw beyond the $9,000 you invested.
Roth 401(k)s & 403(b)s
It gets more complicated when you want to withdraw money from a Roth 401(k) or similar account.
First, as with traditional 401(k)s, the administrator may not allow early nonqualified distributions. Talk to your plan’s administrator about their rules.
If they do allow nonqualified distributions on Roth accounts, don’t expect it to be as simple as with Roth IRAs. Rather than allowing you to withdraw up to the amount you contributed without a penalty, they prorate the penalty and taxes.
It works like this: If you invested $9,000, and your account is now worth $10,000, then 10% of your account is considered taxable. No matter how much you withdraw, you’ll pay taxes and the penalty on the 10% portion of your withdrawal that represents earnings in your account.
It’s not perfect, but it’s better than withdrawing from a traditional 401(k) or IRA.
Another common employer-sponsored retirement plan is the savings incentive match for employees IRA, or SIMPLE IRA. While cheaper and more flexible for both small businesses and their employees, it makes a terrible option for withdrawing money to pay off debts.
If you’ve had the account open for at least two years, you pay the standard income tax plus a 10% penalty on early withdrawals. That’s bad enough in itself, but it gets even worse if your account has been open for less than two years — in that case, the penalty leaps from 10% to 25%.
In short, don’t raid your SIMPLE IRA to pay down debts.
7 Alternatives to Raiding Your Retirement Account
Of the different types of retirement accounts, only a Roth IRA makes for a consistently viable option for plundering to pay off debts. Even then, it depends on the cost of the debt and your expected returns.
So if raiding your retirement account to pay down credit card debt and student loans doesn’t look so appealing, what other options should you consider?
1. Boost Your Savings Rate
No one likes hearing it, but the best way to pay off your debt faster is simply by spending less and funneling more money toward paying it off.
Start by maximizing your savings rate. In particular, focus on cutting the three most significant expenses: housing, transportation, and food. These typically account for between two-thirds and three-quarters of most Americans’ spending, according to the United States Bureau of Labor and Statistics.
If you can trim those three expenses, you can achieve a drastically higher savings rate. For example, you can reduce or eliminate your housing costs by using strategies for house hacking, or finding a free place to live.
You can also try temporary spending freezes or savings sprints to achieve short-term goals like paying off debts. They don’t work as well for higher debts, as they’re difficult to sustain for years on end, and they require serious discipline on your part — discipline most people just can’t maintain forever.
Instead of a short-term sprint, try automating your higher savings rate. The beauty of automation is that it requires less white-knuckle discipline on your part.
Chime is a financial technology company, not a bank. Banking services provided by The Bancorp Bank, N.A. or Stride Bank, N.A., Members FDIC.
2. Ask for a Raise
If you’ve already cut every possible penny from your spending and can’t think of any ways to cut further, you can attack the problem from the other side: earning more money.
That helps regardless of your debt and spending — as long as you can avoid lifestyle inflation, that is.
If you can’t get a raise or promotion at your current job, don’t be afraid to look for a new one. You can also look for a new career, perhaps even one that provides free housing to help you save even faster.
3. Start a Side Hustle
You don’t have to get a promotion or a new job to earn more money. Side hustles can be fun, lucrative, and even help you ease your way into a new career.
For example, I invested in real estate on the side long before it became central to my career at large. Beyond being a source of passive income and property-related tax benefits, my real estate investments paved the way for later career moves as an e-commerce executive, entrepreneur, educator, and freelance writer.
In some cases, you can even turn a hobby into a money-making business.
There are many popular side gigs and hobbies that can generate income for you. You could deliver food with DoorDash or groceries through Instacart. You could start teaching English online or you could lounge on your couch and complete surveys through Survey Junkie.
Just find the one that’s right for you.
4. Do a Balance Transfer
High-interest credit card debt is demoralizing and expensive. But you have a couple of options to lower the interest costs.
First, you can open a low-APR credit card and transfer your existing high-interest balances to the new lower-interest card.
When you do this, less of your payment goes toward interest as you pay down the account balance. And sometimes, it feels less overwhelming and intimidating to consolidate several credit card balances onto one card.
Better yet, what if you could get a one- to two-year reprieve from interest payments altogether? Some of the best credit cards for balance transfers offer 0% APR for an introductory period, often between one and two years.
For example, the Citi Simplicity card offers an impressive 21-month 0% APR period, giving you nearly two years to pay off your existing credit card debt without spending another cent on interest.
5. Negotiate the Debt
Everything in life is negotiable.
Well, maybe not everything. But more than you realize, and one of those things is debt.
Call your creditors and discuss options for debt relief. The worst they can do is turn you down, and they may be willing to work with you to lower your monthly payments (with either a lower interest rate or an extended loan term), lower your principal balance, or some other custom arrangement.
If you’d prefer to have someone else handle the work of negotiating with creditors, you could use Freedom Debt Relief.
But remember that negotiating your debt structure can impact your credit. Make sure you understand any implications for your credit score before agreeing to a debt modification.
6. Borrow Money From Friends or Family
It often feels like you’re alone when you’re neck-deep in debt, but you’re not. Your friends or family may be willing and able to help you get out from under high interest payments.
Before opening that conversation, though, understand that borrowing money from a friend or family member changes the dynamic of your relationship. And if you default, you can ruin the relationship entirely.
Only consider this route if you’re 100% sure you can pay the person back, and within the time limit you promise. To do otherwise is disingenuous and can also create a ripple effect across your other personal relationships as word gets out that you reneged on your promise to repay the loan.
Pro tip: If you want the loan to be more formal, you could use the Zirtue app. With Zirtue, you’ll be able to manage everything, including the loan amount, the interest rate you choose, and any terms for the loan.
6. Cash Out Assets From Your Brokerage Account
Just because you shouldn’t sell stocks from your retirement account to pay off your debts doesn’t mean you shouldn’t sell stocks at all. If you have a regular brokerage account, sell off some of your portfolio to pay off high-interest debt.
Sure, it involves losing out on the potential returns from those stocks in the future. But the math is simple:
If your credit card charges 25% interest, and the stock market historically returns 7 to 10%, then you’re paying three times as much to keep that credit card debt as you could expect to earn from your stocks.
Also, paying off that credit card offers you a guaranteed 25% return. Your stocks offer only the potential for returns. They could always lose money instead.
7. Take Out a Debt-Consolidation Loan
It’s rare for debt consolidation loans to make sense financially. But it’s still an option and could still make more sense than pulling money from your IRA or 401(k).
From second mortgages to refinances to personal loans, plenty of lenders are happy to shove money at you to pay off your existing debts. They sell it to you by showcasing lower monthly payments than the combined sum of your existing payments.
What they don’t emphasize is the fact that you’re spreading that debt over a much longer time frame and could still be paying for last year’s stereo 30 years from now.
They also fail to explain how simple-interest amortization works. It’s not simple at all, but the short explanation is that they front-load the interest so that most of your monthly payment goes toward interest at the beginning of your loan. You make a very small dent in your principal balance until you near the end of the loan term.
And they don’t want you to reach that point. After you make some progress in paying the balance down, they’ll offer you another loan with more money. That resets the clock on your debt once again.
Just remember that the point is to get out of debt, not to extend it further into the future.
Many debts cost more in interest than you could expect to earn by investing the money yourself. That makes high-interest debt a priority over new investments.
But if you owe multiple debts, how do you decide which to prioritize and pay off first?
There are a few schools of thought on this. But three popular ones are the avalanche, debt snowball, and debt snowflake methods.
With the avalanche method, you funnel all your monthly savings into paying off the highest-interest debt first. When you pay it off, you then shift all your savings to the next-most expensive debt. Then the next, and so on until you’re debt-free.
With each debt you pay off, you free up more monthly savings to go toward the remaining debt, and you start accelerating your debt payoff, assuming you don’t add any new debt.
The debt snowball method works similarly, except instead of focusing on the highest-interest debt first, you focus on the smallest debt first, then the next smallest, and so forth.
The advantage to the debt snowball is that you see tangible results faster. That psychological reinforcement keeps you plowing forward, even when the going gets tough.
While the debt snowball and debt avalanche methods work fastest, try debt snowflaking if you find yourself so strapped each month you can’t spare a consistent amount.
Debt snowflaking involves putting every irregular windfall — no matter how small — toward your debts. That includes everything from your tax refund to finding an extra $5 in your jacket pocket.
When you finally escape from the yoke of debt, curious things start happening to the way you think.
For the first time in years, you find yourself with spare money. You then ask yourself a simple but powerful question: “What can I do with my extra money to build wealth?”
Instead of thinking defensively about clawing your way out of debt, you start thinking offensively about getting richer, about new possibilities.
Get out from under your debt, and you find yourself dreaming bigger dreams. And the higher you set your sights, the higher you’re likely to go.
1The Annual Percentage Yield (“APY”) for the Chime Savings Account is variable and may change at any time. The disclosed APY is accurate as of November 17, 2022. No minimum balance required. Must have $0.01 in savings to earn interest.