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Why you shouldn’t use retirement savings to pay off debt

Cashing out retirement savings brings penalty fees and tax bills.Associated Press/File 2013

WASHINGTON — For many workers, years spent building up retirement savings can fall apart at what would typically be a milestone worth celebrating: the start of a new job.

The ability to cash out a retirement account — it arises when you leave the old job — comes with consequences. You’ll have to pay taxes on the money, along with a 10 percent penalty for early withdrawal. Still, it’s an all-too-tempting option for some.

Rather than rolling over that retirement money into an IRA or another savings account, some people simply take the money and walk. And they’re more likely to do so when they have debt, a report from the Employee Benefit Research Institute shows.


For instance, only 12.4 percent of respondents with no debt cashed out their accounts after changing jobs, according to the study. But that share increased to 27.3 percent for people who owed between $3,000 and $10,000.

People also became less likely to roll over savings into an IRA as debt levels increased. Nearly 28 percent of people with no debt decided to roll over their savings into an IRA, compared to about 11 percent of people with $10,000 or more in debt.

The study looked at retirement data from 2008 and 2010, when retirement savers were asked what they did with their retirement plans after leaving a company. Behavior varied not only by debt, but by income.

People who made less were also more likely to cash out their savings. More than 30 percent of those who made less than $25,000 a year cashed out, compared to about 10 percent of those who made more than $75,000.

The survey did not ask people if they were planning to use the cash to pay down their debts, but using tomorrow’s income to pay down today’s debts can come with a cost. For one thing, the pot will be worth a lot less after taxes and fees.


Take a hypothetical 30-year-old who cashes out $16,000 from a retirement account. That person would pay $3,200 in federal and state taxes, along with $1,600 in penalties, leaving him with $11,200, according to an analysis by Boston-based Fidelity Investments.

He would also miss out on the investment growth he would have seen had he left the money invested, says Jeanne Thompson, a vice president at Fidelity. ‘‘It could grow significantly over the course of your career,’’ she says.

People should weigh how much they might earn by keeping the money invested against the cost of carrying credit card debt. The growth on the investment could outpace any savings a person would see from paying down the debt.

For instance, that 30-year-old paying off $10,000 in credit card debt (at an average interest rate of 15 percent) might rack up more than $5,000 in interest charges over 10 years of making $200 monthly payments, calculates Jack VanDerhei, research director for Ebri.

The same amount invested with the typical asset allocation for someone that age could nearly double over 10 years to about $19,600 when adjusted for inflation, VanDerhei says. That amounts to about $4,600 in lost investment growth. (This does not factor in that a person would need to withdraw more than $10,000 in order pay off the debt in full, after taxes and fees.)

Of course, paying off the debt could help people catch up on their savings later. Eliminating debt can help improve a person’s credit score, which can in turn affect the jobs they land and how much they pay in interest on other loans.


Age also plays a role in how people will treat savings.

A separate study by Vanguard found that people in their 20s are more likely to withdraw their savings than older savers. Some people may underestimate how much even a modest amount of savings can add up to over time and so don’t see the value of leaving it in a retirement account, says Maria Bruno, senior investment analyst with Vanguard. But by withdrawing the funds, younger investors are giving up the advantage they have of starting early. They miss out on the power of compounded interest.

And they may need to make much larger contributions later to catch up, Thompson says. ‘‘They will at some point probably need to double down on saving,’’ she says.