Source: ezinearticles.com
If you are struggling with high-interest debt, you may be considering tapping the one resource you have left: your 401k, 401b, IRA, or other retirement savings. Though it may not seem like it now, you will retire someday. When you do, you'll need money to live, and Social Security alone won't be enough. You need to save money, and a lot of it, to live comfortably through your retirement years.
Penalty Box If you withdraw money early (before age 59-1/2) from a tax-deferred retirement account, you'll owe the IRS income tax on the amount withdrawn at your normal marginal income tax rate PLUS, unless the money's for an "allowed purpose," a 10 percentage point penalty. So if your normal marginal income tax rate is 15%, you'd pay 25% tax (15% + 10% penalty) on money withdrawn early from a tax-deferred retirement account.
Say you're thinking of withdrawing money from a retirement account to pay off $20,000 in credit card debt. To be sure you've got the money to pay the big tax bill on your withdrawal when April 15 the following year rolls around, you'd have to withdraw from your retirement account $26,667 (if you're in the 15% income tax bracket). Why? Because that's how much you'd need to withdraw to have $20,000 for the credit card companies and still set aside what you'd need to pay the income tax + penalty of 25%.
What About a Loan? Some workplace retirement plans allow participants to borrow from their accounts. If you borrow from your tax-deferred retirement account, you wouldn't have to pay any tax on the loan proceeds, unlike a withdrawal.
Before borrowing from a workplace retirement account, consider the following:
You'll be required to repay the loan by automatic paycheck deduction over 5 years (longer if for a house purchase). How would this reduction in your take-home pay affect your ability to keep up with your bills? You would not be allowed, income tax bracket, to suspend or reduce your retirement plan loan payments if you get behind on bills, so be sure you can live on the new, lower take-home pay.
If you leave your job, by choice or not, the balance of any retirement plan loan likely will be due right away. If you didn't have the cash to repay the loan balance, the IRS would then consider any unpaid balance an early withdrawal. You'd have to pay tax on it plus maybe a 10 percentage point penalty (depending on how you spent the loan proceeds).
If you borrow money from your retirement account, your account won't grow as large as it would have if you'd left it alone. To estimate the effect, use this calculator.
Borrowing from a retirement account may, in certain situations, make sense, but other options are better in the large majority of cases. A free credit counseling session can help to identify and sort through your options for paying off high-interest debt. What about future contributions to your workplace retirement plan? If necessary to help a well thought out debt pay off plan succeed, and only after you've cut your living expenses and increased your income as much as you can, it's okay to reduce temporarily your contributions to a retirement plan. If your employer makes a matching contribution to your account, try to keep contributing enough of your own money to get the full match. If your situation improves, restarting some or all of your retirement account contribution should be at the top of your list of options for what to do with extra money. Don't start splurging on dining out, travel, and other non-necessities before you're again making the maximum contribution allowed to your retirement accounts.
Kurt Fischer is a certified credit counselor and founder of http://www.MyMoneyCounselor.com