It’s a question all consumers struggling with debt will have to confront at one point or another: Should I use my savings to pay off my credit card bills?
Generally speaking, I don’t think it’s a wise idea to tap into savings, especially things like retirement savings, in order to pay off credit card debt.
Instead, I prefer to see people pay off debt “organically” using their earned income, as well as creative strategies, such as reducing household expenses or selling things they don’t need.
However, there are many exceptions to this advice, so the final answer to whether to pay off debt with savings is rarely cut-and-dried.
For one thing, there’s a lot to take into account when making this decision: factors like your age, your job stability, your other sources of income or savings (if any); and the risk that other things in your life could go wrong.
Let’s talk about age as a factor in the decision-making process. Most people who might be looking to tap their 401(k) plans to reduce debt — including those in their 20s, 30s, 40s and 50s — are going to be hit with a 10% IRS penalty if they withdraw retirement savings prematurely.
These individuals will also have to pay ordinary income taxes on their 401(k) withdrawals.
A final downside: by taking money out of your retirement savings, there’s an “opportunity cost” — the missed potential that your money could have been earning interest over time.
Having said all this, I could certainly make a case for using various forms of savings to pay down credit card debts. I could even envision circumstances when someone might be better off tapping retirement funds to reduce debt.
Here are two examples.
Assume you are 40 years old with $20,000 (thanks to a nice Aunt!) sitting in a bank account earning about 1% interest yearly. If you’re paying about 15% in annual interest, the average rate on credit cards these days, it’s almost a no-brainer: Go ahead and use the savings to alleviate the debt.
But the situation gets a little trickier if your employment situation is shaky or if that $20,000 is all the money you have left in the world to fall back on in the event of an emergency.
What if you lose your job? What if your car gets totaled? What if you have a medical illness and can’t work?
Wouldn’t it be nice to have some savings to tide you over in each of these cases?
That’s why as much as it makes people feel better to use savings to eliminate debt, it can also lead to emotional stress if you completely deplete your savings and later regret it because you need the money for some other important purpose.
Now what about that 401(k) money?
Well, older people who are closer to retirement may be just fine using some retirement cash to pay off debt.
For instance, those over the age of 59 1/2 who take a distribution from a qualified retirement plan, such as an employer-sponsored 401(k) or a 403(b) plan, will not have to pay that 10% IRS penalty that hits younger workers.
Also, as individuals get closer to retirement the need to pay off debt is greater.
Once you stop working, reducing debt can be hard — especially since other costs, like healthcare and insurance may rise.
So for those within five years or so of retirement, using savings to reduce debt could make perfectly good sense. Not to mention, it gives pre-retirees and those easing into retirement a priceless bonus that can’t be measured in dollars and cents: peace of mind.
The key is to evaluate all your circumstances when making decisions about your savings and debt.
Explore what other options you have to pay off credit card bills before draining a savings nest egg of any kind.
But in the end, if you’re forced to liquidate a savings account, at least make sure that once you pay off the debt, you don’t rack it up again in the future.
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