Should you use retirement funds to pay off debt?

If you have high credit card balances, student loans or a mortgage, it's tempting to use retirement funds to pay off debt. But whether you're considering taking an early withdrawal or you're retired and eager to get rid of that monthly mortgage payment, it's not typically the best use of your funds.

We'll explain why using retirement funds for debt repayment may not be the right choice, how best to pay down debt with your retirement savings if you do decide to take that path, and alternative ways to manage your debt. We'll also explore how to think about holding debt in retirement.

Generally, using retirement savings to pay down debt is not recommended. When you take money from a retirement plan early, you not only reduce your savings, you also lose out on potential tax-free compound interest, which allows your investment to grow at an accelerated rate over time. Money invested in a Traditional 401(k) or IRA plan grows tax-deferred, meaning you don't pay taxes on your earnings until you begin withdrawals.

Let's say you're 40 years old and have $100,000 saved in a 401(k). If you leave all that money in the plan for 25 years at an 8% annual return, you will have $684,848 at age 65, without factoring in any additional contributions. But let's say you decide to take $50,000 out of your $100,000 balance to pay off debt. Before paying any taxes or penalties, your savings only will grow to $342,424 by age 65, before penalties and taxes triggered by early withdrawal.

Retirement plans offer the ability to reduce your taxable income today and provide tax-deferred growth to encouraging people to save for the future. But withdrawing money early from a retirement account such as a Traditional 401(k) or IRA results in a 10% penalty and a potentially hefty tax bill. These penalties can significantly reduce the amount available for debt repayment.

If you're 59 1/2 or older, your withdrawals won't trigger the 10% penalty, but your withdrawal still will be taxed as income at your current tax rate.

If you decide to take money from your 401(k), you may have a second option to a direct withdrawal, if the plan document allows. A 401(k) loan allows you to borrow up to 50% of your vested balance in the plan or $50,000, whichever is less. Note that you typically have to repay the borrowed amount within five years. You also will pay interest, but the interest goes into your account. Your plan also may require you to pay back the entire loan once you leave your employer—and research shows that 86% of workers default on 401(k) loans after leaving a job.

Roth IRA accounts have an exception that allows you to take out your contributions tax- and penalty-free at any time. Still, by withdrawing Roth funds early, you risk missing out on tax-deferred savings growth. If you hold a Roth account and decide to pay off debt, the most effective strategy is to take out the money you need, pay off that debt and then quickly replace the money in your Roth account. This method will hurt your retirement savings the least.

If you need to repay debt, consider alternatives to using retirement funds. The best option for you depends on your personal financial situation, the type of debt and how much debt you owe. Many factors such as home ownership, life insurance ownership and credit rating influence your choices. Explore options like personal loans, second mortgages and debt consolidation.

As you think about whether to save for retirement or pay off debt, keep in mind that not all debts are the same. First evaluate the difference between good and bad debt. There are benefits to keeping low-interest "good" debt, such as mortgages or student loan debt, and paying them off slowly. For instance, with each mortgage payment you make, you own a bit more of your property. On the other hand, "bad" debt—including interest-accruing credit card balances and payday loans—generally provides no long-term benefits and keeps you underwater.

Here are some ways to tackle debt without dipping into your retirement savings:

Are you trying to pay off a high-interest debt? Obtaining a personal loan at a lower interest rate can help you pay off that debt and reduce your overall debt cost. You can apply for a personal loan at a bank or credit union.

If you own your home and have built up some equity value, you may be able to access funds through a home equity loan, or second mortgage. With this type of loan, you can access a lump sum of cash to pay off debt, often at a relatively low interest rate because your property backs the loan. You repay this loan in monthly payments, similar to your existing mortgage terms.

Permanent, or whole life, insurance policies build up cash value over time. You can withdraw some of that cash value to pay off debts without having to repay what you withdrew. However, you will reduce the policy's eventual death benefit.

If you have credit card debt and a high credit score, you can transfer your balance to a new card with a low, or even 0% APR. Moving your debt won't decrease what you owe, but it can reduce your total cost by lowering the interest it accumulates.

Another option is merging your credit card balances into one account with debt consolidation. If you apply and are accepted for a fixed-rate consolidation loan, your rate won't change for the life of the loan.

Be sure to carefully consider your situation before acting. A financial advisor can help you determine a debt repayment strategy that also considers your future financial needs.

If you're approaching retirement with a mortgage left on your home, you may be wondering if you should just pay off it off before you retire. There are pros and cons, depending on your situation.

Reasons to have a mortgage in retirement:

• You hold a fixed-rate mortgage with a rate that's lower than the current rate of inflation. That means you're repaying your mortgage with dollars that don't go as far as they used to.
• You may need to borrow money in the future. If you anticipate future expenses such as paying for a child's wedding or major home repairs, obtaining a second mortgage or tapping a home equity line of credit could be a cheaper option than credit card debt.
• If you itemize your tax deductions and claim mortgage interest as a deduction, holding the mortgage may help you save on taxes.

Reasons to pay off your mortgage before retiring:

• The inflation rate is lower than your mortgage rate. If you have enough savings to cover your projected retirement expenses and a healthy emergency fund, then paying interest to maintain your mortgage may not be necessary.
• You claim the standard deduction on your taxes and can't deduct your mortgage interest.
• You won't feel comfortable holding a mortgage in retirement.

You can reduce debt before reaching retirement without tapping into your retirement savings. Look for ways to cut expenses to free up money you can put toward debt. Cooking meals at home, moving into a less-expensive home, spending less on travel and entertainment and putting any extra money toward what you owe can all help chip away at your debt.