This Is the One Thing You Should Never Do When You're Dealing with Debt

When you owe a lot of money to creditors and are eager for debt relief, chances are good you're looking for every available source of funds to pay back what you owe. However, there are things worth avoiding when you're dealing with debt. 

In some cases, making sacrifices to pay off debt can be a really good thing—for example, selling unwanted items and curbing impulse spending. So is working with a credit card counseling service to make a plan to repay what you owe.

Here’s one sacrifice that can feel really appealing when times are tough—and why it’s something to avoid anyway. 

Skip This Option When You're Struggling with Debt

When you owe money and are having a hard time paying it back, it may be really tempting to tap into a potentially big source of cash: your 401(k) plan or other retirement plan.

You may have been putting money into your 401(k) or IRA because you signed up to do it, or because you were automatically enrolled. Either way, if you have a sizable amount of money in your account, it may seem like a good idea to cash it in and send the money to your creditors. However, there are solid reasons not to do that. 

Your 401(k) is protected and essential

One of the biggest reasons not to cash in your 401(k) to pay off your debts is that your 401(k) is protected from garnishment and in bankruptcy. No creditor can take it from you. 

There's a good reason for that, too. It’s meant to help support you as a retiree, since Social Security only replaces 40% of pre-retirement income. 

If you have a lot of debt, tapping your 401(k) may not be enough to fix the issue for you anyway. You could use your retirement funds to make payments or pay a lump sum, but still be in debt, struggling to pay the bills. You could also find yourself settling your debt or filing for bankruptcy anyway. So it's better to keep your 401(k) funds, which remain safe and protected, no matter what else happens. 

If you don't have a substantial amount of debt, you can work on other plans to pay it over time, and avoid raiding your retirement account. 

Cashing in a 401(K) comes with big penalties

Cashing in your 401(k) or other retirement plan doesn't make sense in most cases because of the tax implications. If you take money out before age 59 and a half, you're likely to get hit with a 10% penalty, unless you qualify for a very limited hardship exemption. This eats up some of the money you worked hard to invest, and would leave you with less to send to your creditors.

You’re also taxed on withdrawals at your ordinary income tax rate. Because you owe the penalty and taxes, you may not end up with as much money as you expected, or as much as you need to pay your creditors.

If you withdraw $15,000 and you owe a 10% penalty and 22% tax on the withdrawn funds, you pay around $4,800 in taxes, and only walk away with around $10,200.  This may make it even less likely that your retirement account withdrawal will enable you to become debt-free.

You'll miss out on compounding

Finally, it's worth noting that if you take out money from your 401(k) plan to solve your current debt problem, you lose out on compound growth that could have helped you to build your wealth over time. 

Compound growth happens when your money is invested, earns returns, and those returns are reinvested. That helps you start with a larger pot of cash when you need it in the future. When you have money in your retirement account, compounding allows that money to work for you so you don't have to personally invest every dollar towards a secure retirement.

Taking money out means missing out on all the compounding that would have occurred on that money until retirement. You could end up with many thousands of dollars less, and you'd likely have to struggle to invest much more later to make up for the missed years of compound growth. 

There Are Other Good Options for Debt Relief

The last reason not to tap your 401(k) or other retirement plan is because there are often better options. You could use a loan to consolidate debt, enter into a debt management plan, or negotiate a lower payoff with your creditors. 

Freedom Debt Relief can work with you to understand your options and to learn how to get relief from credit card debt or other loans without putting your retirement on the line. Contact Freedom Debt Relief ASAP—especially before taking money out of your retirement plan—to find a solution that works for you.