Getting rid of debt is great for your financial health, but becoming debt-free shouldn't come at the expense of your future.
That's why you shouldn't use money from your retirement fund to pay off your student loans or eliminate credit card debt, says financial expert and bestselling author of "Women and Money" Suze Orman.
About 11 million Americans tap into their 401(k)s each year. Though Orman understands the temptation, she warns that taking a loan from your 401(k) to pay off debt is the "biggest mistake you will ever make."
Taking a loan from your 401(k) is different than withdrawing from it. If you choose to cash out all or part of your 401(k), you'll be forced to pay both state and federal taxes, as well as a 10 percent penalty for withdrawing before you reach age 59 ½.
If your plan allows you to take out a loan from your 401(k), you don't have to pay taxes or a penalty. Instead, you take money directly out of your balance and a develop a plan to pay yourself back. That repayment plan includes the amount you took out, plus interest.
But, as with a withdrawal, you'll lose out on that money's potential tax-deferred growth. With compounding interest, a little money added earlier can add up to more than a lot of money added later.
The interest caveat in your repayment plan may make it seem like you're paying back the amount you would have lost by leaving your money alone and letting the interest compound. But when you sell, your shares are no longer growing in value. That means you could lose a lot more than interest.
Also, unlike your original pre-tax contributions to the account, the loan payments are made with after-tax dollars. Because you're putting those payments back into a pre-tax account, you'll have to pay taxes on that sum again when you withdraw the money during retirement.
In other words, "you just volunteered for double taxation," Orman says.
Taking a loan from your 401(k) typically comes with a five-year time limit. If you aren't able to make the repayment in time, you'll be charged a 10 percent penalty for taking money out of your 401(k) before reaching age 59 ½.
And if you lose your job before everything is paid back, the amount you owe will be taxed as ordinary income, Orman says.
The best way to avoid these complications is simple: Leave your retirement accounts alone.
"Do not take a loan, do not make withdrawals, do not touch your retirement accounts," Orman says. "Because if you think you need that money now, I'm here to tell you you're going to need it even more later on in life when you no longer have a paycheck coming in."
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