People facing debt collection are often tempted to dip into retirement funds to pay debts. While this has never been a good idea, using up retirement funds to pay debt is increasingly risky with the recent projection that the Social Security trust fund will be depleted by the year 2034. Beginning in 2034 it’s now expected that Social Security recipients will have their benefits cut by nearly 20%. The outlook for Medicare is equally dismal, with benefits projected to be cut in 2033. Taking money from retirement funds such as an IRA or 401(k) to pay off debts should never be the first choice when a bankruptcy could instead be used to both discharge debt and preserve retirement funds. Below are things to consider:
- Irreplaceable Retirement Savings
- Early withdrawals are hard to recover: Once funds are withdrawn from a retirement account, especially early in life, they lose the power of compounding interest. It becomes difficult, if not impossible, for many individuals to rebuild that nest egg before retirement.
- Reduced financial security in old age: With Social Security benefits projected to be reduced after 2034—possibly by around 20% or more—retirement accounts will be an even more critical safety net.
- More personal responsibility for retirement: If Social Security is reduced or restructured, retirees will need to rely more heavily on personal savings to cover living expenses.
- Loss of dual safety nets: Drawing down retirement accounts now could mean facing retirement without sufficient private savings or full public benefits.
- Taxes and Penalties
- Early withdrawal penalty: If you’re under 59½, taking money from a 401(k) or IRA typically triggers a 10% penalty on top of regular income tax.
- Taxable income increase: The amount withdrawn is taxed as ordinary income, which can push you into a higher tax bracket, increasing your tax burden.
- Bankruptcy Protections
- Retirement funds are protected in bankruptcy: Under law, most retirement accounts—such as 401(k)s and IRAs—are exempt from creditors in bankruptcy proceedings. Using these protected funds to pay off dischargeable debt wastes an asset that would otherwise be safe if you filed for bankruptcy.
Tapping into retirement savings to pay debt is a high-cost, high-risk decision. With the anticipated weakening of Social Security and Medicare support by 2034, preserving personal retirement funds is more critical than ever. Talk with Nancy L. Thompson Law Office about whether bankruptcy is a better path to protect long-term financial health.
