Dear Dr. Don,
I have around $83,000 in retirement accounts. I also have around $48,000 in student and parent loans. I will turn 59 ½ this month and am considering withdrawing around $35,000 to pay down some of this debt. Do you think this is a sound financial move? Thanks,
-- Jim Juxtaposes
It's a great goal to reduce your debts prior to retirement, but it doesn't make sense for a person to raid his retirement accounts toward the end of his working career. Sure, it would cut down on your interest payments, but will you have the financial discipline to rebuild the retirement fund? I'd rather see you make additional principal payments out of current income than to deplete the retirement accounts.
I understand why you're thinking about this now. When you're 59 ½, you can avoid the 10 percent penalty tax on early distributions from your retirement account. However, you still have to pay the income taxes due on the distributions out of tax-deferred retirement accounts. If you're in the 25 percent bracket, you'll owe $8,750 in federal income tax on a $35,000 distribution.
You can argue that you'd take the income tax hit eventually in the retirement accounts. But you'll probably drop to a lower tax bracket in retirement, so the money taken out now may cost you 5 percent to 10 percent more in taxes than keeping it invested into retirement. By paying the taxes now, you've also reduced the amount of money that's working for you in the retirement account.
If you decide to do this, put together a strategy that has you paying off -- rather than paying down -- loans. Additional principal payments don't reduce the loan payment. They just reduce the total interest expense and shorten the loan term. You want to shed loan payments and use the extra cash to rebuild your retirement accounts. Within that constraint, you want to focus on the loans with higher interest rates.