What Is The Rule Of Thumb About Emergency Savings Vs Debt Payoff
The general rule of thumb is to do both: Pay off debt while building your emergency savings. Saving at the expense of accelerating debt repayment ignores the importance of commitment to do both now, he said. It should never be an all-or-nothing option, said Todd Christensen, education manager at Money Fit by DRS, a nonprofit debt management agency.
If you wait to pay off debt before saving for emergencies or even retirement, but then never manage to pay off the debt, one day you may realize that it’s time to retire and that you are completely unpreparedand, perhaps, still in debt.
You could weight contributions toward your emergency savingsfor a while, at least. Christensen suggested saving up a small nest egganywhere from $500 up to the amount of one months living expensesif you dont have anything put aside right now. But continue to pay more than the minimum on your debts.
For example, suppose you have $100 in discretionary funds per month to put toward emergency savings, debt, or both. In this case, send an extra $5 or $10 to each debt account, and focus the rest on savings.
“Discretionary” spending means the amount of money you can set aside each month beyond your living expenses.
Take discretionary funds out of every paycheck right away, versus seeing whats left at months end. You never have money left over at the end of the month, he said, meaning youve probably already spent it all.
The Bottom Line On Borrowing Against A 401 To Pay Off Credit Cards
Taking out a 401 loan can be a flexible and affordable option for paying off credit card debt. Still, if youre going to go this route, its best to proceed with caution. At a minimum, youre going to want to take some time to reflect on your financial attitude and spending habits. Once you borrow against your retirement account to pay off debt, its a good idea to examine your budget and spending habits regularly. Doing so can help you avoid ending up with debts that feel overwhelming.
If you have more questions about ways that you can consolidate your debts, call us at 890-7337 or fill out our short contact form. Well be in touch with more information about how we can help you.
Withdrawals Before Age 59
If you pull money out of your 401 plan before age 59½, thats generally considered an early or premature withdrawal and subject to both income tax and a 10% early withdrawal penalty.
Suppose you take $45,000 from your 401 to pay off debt. For starters, youll face a $4,500 early withdrawal penalty. On top of that, youll also owe income tax on the $45,000. For example, if youre single, and your other taxable income is $100,000, then your $45,000 withdrawal will be taxed at 24%, or $10,800 .
So, in total, your $45,000 withdrawal will cost you $15,300 and leave you with $29,700 to apply to your debts.
Top Credit Card Wipes Out Interest Into 2023
If you have credit card debt, transferring it to this top balance transfer card secures you a 0% intro APR into 2023! Plus, youll pay no annual fee. Those are just a few reasons why our experts rate this card as a top pick to help get control of your debt. Read The Ascent’s full review for free and apply in just 2 minutes.
Options For Using A Pension To Pay Off Debt
When it comes to using a pension to pay off debt, you have two main options: a lump sum or a pension contract.
- Lump sum: You can take out a 100% cash lump sum, which can be used toward your debt payments.
- Pension contract: You can transfer your pension fund to an approved pension contract, which puts you in control of the funds. Similar to a savings account, you can then access the funds and use them for whatever you like.
With either option, once you get the funds, you can use them to pay off your debts
If you pass away, you can transfer your pension to your heirs. If this happens before you turn 75, the death benefits are paid with no tax involved.
Read Also: How Is Retirement Divided In Divorce
What Are The Different Types Of Retirement Accounts
Before considering the costs of early withdrawal, its important to understand the difference between traditional and Roth accounts. Each is handled differently in case of early distribution.
A traditional retirement account is contributed to with pre-tax dollars. Contributions and earnings will be taxed when distributed.
A Roth retirement account is contributed to with taxed dollars. Contributions and earnings will be distributed tax-free.
You should also know the difference between the two main types of retirement accounts 401 and IRA.
A 401 is an employer-sponsored plan typically made up of funds chosen by your employer. If you have automatic contributions from your paycheck into a retirement account, you likely have a 401 plan. Many employers also offer a Roth option.
An IRA, or individual retirement arrangement, isnt employer-sponsored. You open it yourself and choose the funds that make it up. Traditional and Roth options are available for your IRA. If you need help opening an account, check out this NerdWallet article on how and where to open an IRA.
Normally, retirement accounts cant be distributed until after the age of 59½. If you withdraw money early, youll have to pay taxes and penalties. Youll also miss out on the biggest benefit of investing future gains.
Should You Withdraw Your Retirement Funds Early
Short answer no!
Longer, clearer answer even if your credit card interest rates are higher than your tax rate, its almost never a good idea to withdraw your retirement savings early. Heres a rundown of the types of retirement accounts you may have and the costs youll incur if you withdraw from them before retirement.
Read Also: How To Figure Out What To Do In Retirement
How Old You Are
If you are in your 20s or 30s and have a large amount of high interest debt it probably makes sense to focus mainly on paying down those debts, while still contributing something to your retirement account. Because you still have time to make up your retirement savings , still making contributions to save for retirement during this time will allow you to benefit from compound interest. However, as a 50-60 year old in the same situation, it may make more sense to focus equally on both areas, or even prioritize retirement savings in order to make up for lost time.
What Is The Rule Of Thumb About Paying Debt Vs Investing
In general, the rule of thumb is that you should both pay debts and invest. In fact, try to consistently contribute to three bucketsdebt payoff, retirement, and an emergency fundsaid Linda Davis Taylor, former CEO of Clifford Swan Investment Counselors in Pasadena, California, and host of the podcast Money Stories with LDT. Even if that means you can only contribute $10 or $20 per paycheck per month to retirement or savings in addition to debt payoff, its worth doing.
If you overcommit to investing and only make minimum debt payments, you could wind up paying too much in interest over time, he pointed out, which can hamper your ability to buy a home or start a family. If you neglect investing entirely, however, you may fall short of your retirement goals.
Don’t Miss: T Rowe Price Retirement 2015 Adv
Advantages Of Withdrawing Retirement Funds For Your Home Loan
Some people are comfortable with keeping debt and making a monthly payment. But for others, the benefits of eliminating debt are clear.
No More Monthly Payment
By paying off your mortgage loan, you get rid of one of your biggest monthly expenses in retirement. Yes, youll still have healthcare expenses and other costs, but reducing your monthly obligations gives you more breathing room and could reduce stress as you prepare for retirement.
Stop Paying Interest
A home loan might be a substantial amountwell over $100,000that generates meaningful interest charges. By paying down the debt, you reduce the financial drain on your resources. Plus, if your money is sitting in cash-like investments or a bank account, its probably not earning as much in interest as youre paying on the mortgage. You might save tens of thousands of dollars by wiping out that debt.
No Worries About Market Movements
Your willingness to take investment risks may decrease as you approach retirement. That makes sense, and we know that the sequence of returns issue makes big losses problematic in the years surrounding your retirement date. You might view a lump sum mortgage payment out of your retirement funds as a guaranteed return on the interest costs you avoid going forward.
While there are certainly good reasons to take money from your IRA or 401 to pay off a mortgage, there are also reasons for leaving the money in retirement accounts.
Save Something For Retirement
If you havent started to save for retirement in any way, regardless of your age, you should make that your number one priority. Even a small contribution will make a difference and over time you can increase those contributions, all while you benefit from the power of compounding interest. The sooner you start, the more time you allow compounding interest to work in your favor.
Also Check: Does Pennsylvania Tax Retirement Income
Should You Pay Off Debt Or Save For Retirement
Are you in a situation and wonder whether to pay off debt or save for retirement? If so, this article is for you. Being able to retire means having enough passive income to cover your monthly expenses. Since debt payments eat into your monthly surplus, paying off debt is as essential as saving for retirement. However, striking a balance between paying off the debt and saving is like walking a tightrope.
I can certainly understand and appreciate someone might favor saving for retirement over paying debt. Or vise versa. In my 20s, I spent all the money I made, and then some! At the time, I didnt understand the difference between good debt and bad debt and how high-interest debt could cripple my finances.
No doubt, there are many arguments to consider before deciding whether to save for retirement or pay off your debt. A financial adviser may encourage you to clear the debt first depending on various factors and then start to save for retirement. But before you decide, you will have to weigh the interest rates and the potential returns on your investments.
Lets assume you are carrying $10,000 in credit card debt at 20% APR. If you pay off the debt, youll have a GUARANTEED 20% ROI on your money. And, considering the S& P500 appreciates about 10% a year, this an excellent deal!
Lets get started:
Is Borrowing From 401k To Pay Off Debt A Good Idea
If you have credit card debt, but you have some retirement savings, theres a good chance that youve thought about borrowing from a 401 to pay off debt. While borrowing from your retirement account is certainly an option, like any other financial decision, it does come with its own pros and cons. With that in mind, weve taken the liberty of exploring this option in-depth for you below. Keep reading to learn more.
Read Also: Scholarships For Retired Military Children
Leave Your Retirement Savings Alone
Raiding a retirement account might help you pay off debt quickly, but it could set the stage for financial ruin once you’re older, not to mention cost you money in the form of early withdrawal penalties. You’re far better off cutting back on expenses, boosting your earnings, and managing cash influxes wisely to chip away at that debt until it’s gone.
One more thing — if you can make your debt more affordable, it’ll be easier to pay off, so to this end, see if it makes sense to refinance. You can refinance your credit card debt by rolling it into a new loan, or transferring your balances to a new credit card with a lower interest rate. Both options will lessen the amount of interest you pay and hopefully help you shake that debt sooner rather than later.
How To Use A Retirement Account To Pay Off Credit Card Debt
President of Quest Education, teaching business owners about funding, paying off debt, and investing in alternative assets.
Many Americans have both credit card debt and a retirement account, such as a 401 plan or individual retirement account . This means they are likely losing money faster than they are making it.
According to WalletHub’s Credit Card Landscape Report, interest rates average 17.98% for new credit card offers and 14.58% for existing accounts. In regard to retirement accounts, one commonly hears that investors can expect an average 6%-7% annual return in the stock market over the long term. Losing 17.98% per year on a portion of your money and then making 7% per year on another bucket of money means you could be going backward financially. However, there is a lesser-known option to fix this problem using your retirement account.
Some people consider taking funds out of their retirement account only to discover that withdrawing money from the IRA/401 plan would cost 20%-35% in penalties and taxes to the IRS. That would mean if a person takes out $20,000 from their retirement account to pay off credit card debt, there could be up to $7,000 in penalties and taxes paid.
Don’t Miss: Park West Plaza Retirement Community
Why Should You Be Worried About Future Earnings
If you havent yet been schooled on the magic of compound interest, youre missing out. Basically, the longer you keep your money invested, the more it will grow. So possibly the biggest expense youll incur if you choose to withdraw your retirement funds early is the loss of future earnings.
Lets say you have $20,000 in your retirement account and you want to withdraw it to pay off credit card debt. Estimating a conservative annual return of 4%, if you leave this money alone, it will grow to $64,868 in 30 years. This means, youll be giving up $44,868 by withdrawing your funds early. And thats before factoring in the taxes and penalties.
Even if your credit card interest rates exceed your tax rate, it isnt a good idea to withdraw funds early, for the same reasons.
Before withdrawing retirement savings for any reason, make sure youve exhausted all other possible options, including looking into various forms of debt relief.
About the author:Erin is a credit cards expert and studies writer at NerdWallet. Her work has been featured by USA Today, U.S. News and MarketWatch.Read more
The Dos And Donts Of Borrowing Against Your 401 To Pay Off Credit Cards
You should also make time work in your favor or be aware of the ways in which it could work against you when withdrawing from your 401 to get rid of debts.
Never withdraw more than you need to cover your debts. Any amount that you leave in your 401 will save you a large amount in penalties and earn interest over time, says Martin. And be sure to consider years until retirement and years until full repayment of your credit card debts in your calculations. Time works on both sides of this equation.
Finally, its important to consider other alternatives such as debt consolidation loans, and make sure this is truly the best one for you even if the equation makes sense from an interest rate and fee standpoint. Refinancing credit card debt can be a good way to get it under control without tapping into your retirement funds, adds Martin.
Also Check: How Much Do I Need To Retire Early Calculator
Should I Take Money Out Of My Ira To Pay Off Debt
11 Minute Read | December 14, 2021
If youre in the middle of paying off your credit cards, car loans or student loans, you know that every extra dollar toward debt helps. But if youre starting to consider your retirement fund as a way to dig yourself out of the hole, hold up!
While it may be tempting, taking money out of an IRA to pay off debt is a terrible idea. Not only can that money come with outrageous early withdrawal penalties and taxes, but its also stealing from your future self. Weve broken down what happens when you cash out a retirement fund early, and well tell you how you can pay off debt without raiding your IRA.
Credello: Should You Take Money Out Of Your Retirement Fund To Pay Off Debt
NEW YORK February 28, 2022
Paying off debt is a top priority for many people since debt can be a serious issue that leads to financial instability, reduced access to essential resources, and even bankruptcy. But is using your retirement savings the best way to go about it? Here are a few things you should consider first when deciding to pay off debt or save for retirement:
How much debt do you have?
Debt can be an enormous financial burden, and it can be challenging to get out of debt. To help you figure out how much debt you have, its essential to know your credit score and what your monthly payments cost. You can also use a debt calculator to see how much debt you could pay off in a certain amount of time. If youre to the point that you feel the only other option is bankruptcy, then it might be better just to take the hit on your retirement account and use those funds to pay off your outstanding debt. However, this should only be done when youre out of other options and have a significant amount of debt that you cant pay off by any other means.
What is the interest rate on your debt?
What are the penalties of withdrawing from your retirement fund early?
What is the expected lifespan of your retirement fund?
The bottom line
Press Release Service
Recommended Reading: Orchard Heights Gracious Retirement Living