Californians: Don’t Use Your 401(k) to Pay Down Debts - Borowitz & Clark

Don’t Use Your 401(k) to Pay Down Debts

Your retirement account plays an important role in protecting your future. Unfortunately, 401(k)s and other retirement accounts are in short supply in California. According to a 2019 report from the UC Berkeley Center for Labor Research and Education, 54% of private sector employees in California have no retirement savings account or pension plan. That’s especially troubling since it leaves many future retirees entirely dependent on Social Security–a program currently slated to run out of money in just 17 years

Assuming Social Security lasts long enough for you to get your benefits, it likely won’t be sufficient. In 2020, the average retiree on Social Security in California receives $1,496.13. That’s just $17,953.56 annually. 

If you have a 401(k), you want to build it up and preserve it, not deplete it to pay off medical bills or credit card balances. But, that’s just one reason using your retirement account to pay off debts is usually a bad idea. 

4 Reasons Not to Gut Your 401(k) to Pay Debts

It will cost you much more than you think

People considering taking funds out of a retirement account such as a 401(k) to pay off debts like credit card balances are often swayed by the difference in interest rates. If you’re paying 19% interest on your credit card and earning 5% interest on your 401(k), it seems obvious that you’ll make money by getting rid of the high-interest debt. But, it doesn’t often work out that way. 

If you’re 30 years old today and have $10,000 in credit card debt at 19% interest and you pay that balance off very slowly–across 10 years–you’ll have paid about $12,400 in interest. That’s a big number, and the idea of paying more in interest than your underlying balance is discouraging. But, the analysis doesn’t end there. If you’re 30, that $10,000 will likely be sitting in your 401(k) for another 35 years. At an average return of 5% compounded annually, your $10,000 will be worth $55,160.15 when you retire. That’s a gain of $45,160.15. In other words, you’d have given up $45,160.15 to save $12,400, for a net loss of more than $32,000. That’s almost exactly the per capita annual income in Los Angeles.

And that’s before you consider penalties associated with early withdrawal of tax-deferred retirement funds: tax on the amount withdrawn, plus a 10% penalty. If your plan allows for loans against your 401(k), you may be able to avoid this cost. But, you’ll still lose the interest and compounding until the loan is repaid. And, if you leave your employer before the loan is repaid, you’ll have to find a way to make quick repayment or get hit with those taxes and penalties.

You’re putting your future at risk

Of course, the risks are greater if you’re closer to retirement age and if the withdrawal or loan is large. Still, none of us knows exactly what the future holds. Depleting your retirement account thinking you’ll rebuild later is a gamble. If you’re unable to rebuild as planned, you may have shifted from a path toward a comfortable retirement to facing significant adjustments to your standard of living and financial insecurity at the time you’re least equipped to manage it. 

Your 401(k) is protected from creditors

If you’ve fallen behind on debts and are considering cashing in or taking a loan against your 401(k) because you’re concerned about collection action, you should know that you’ll be giving up one of the few assets that’s generally off limits to creditors. That legal protection exists for a reason–the federal government recognizes the importance of people being able to provide for themselves in their old age. 

If your debt problems are serious enough and you don’t find a solution, you could face lawsuits, lose your home, lose bank accounts and other assets. But, your 401(k) is protected to provide some financial stability in the future. That’s true even if you file bankruptcy. When you close it out or reduce the balance, you’re eliminating or weakening your own safety net. 

There is almost certainly a better option

Using 401(k) funds to pay down debts is an easy go-to. The money is just sitting there, and paying down large debts can be a quick and efficient process compared with other possible solutions. But, of course, your money isn’t just sitting there–it’s growing, and it’s acting as a safety net. It’s well worth your time to explore other options. 

The right answer will vary depending on your specific circumstances. You may be able to negotiate with creditors to craft a more manageable payment schedule. You may want to downsize and cut the budget where you can to gain more control over your finances, or to temporarily take on a part-time job. If your credit is good, you may be able to lower your interest rates and payments with a lower-interest loan or a no-interest balance transfer. Or, if your debt has truly become unmanageable, you may want to consider bankruptcy. 

The bottom line is that there are many possibilities, though they may not be as obvious or efficient as taking money from your retirement account to pay off debt. You owe it to yourself and your family to educate yourself about those options before you wipe out or diminish your retirement account.  In the end the goal is to keep the money you have earned, and tucked away, for your golden years.

Talk to a Los Angeles Bankruptcy Attorney

At Borowitz & Clark, we’ve been helping people resolve debt for decades. We offer free consultations to help you gather the information you need to make the best decision for you and your family. To learn more, schedule a free consultation right now. Just call 877-439-9717 or fill out the contact form on this page.

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