Become Debt-Free

1 in 4 young people dip into 401(k)s to pay off debt—here's why that's a problem

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Survey after survey shows that Americans want to become debt-free. But a significant number of young people are going about it the wrong way, experts say.

A new report by Merrill Lynch and Age Wave, which surveyed over 2,700 Americans ages 18 to 34, found that 25% of those with a 401(k) have already made an early withdrawal. The top reason: credit card debt.

Just under a third (31%) of respondents who raided their 401(k)s say they took out the money to pay off their credit card balance, while 16% said they put it towards student loans.

Debt can feel overwhelming: The average young adult under the age of 35 has a credit card balance of over $5,800.

But experts say the short-term relief you may feel from paying some of it off is not worth the consequences of taking money out of your retirement savings early. "401(k) plans are the worst place to take out a withdrawal or a loan," says Lorna Sabbia, head of retirement and personal wealth solutions at Bank of America.

Why you shouldn't pay off debt using retirement savings

About 40% of working Americans are enrolled in an employer's retirement plan, and 401(k)s are a common savings option.

A 401(k) is a great way to save for retirement because it offers significant tax savings. You can put in money directly from your paycheck before taxes are withdrawn, which reduces your taxable income. That means you will pay less in taxes each year. And because your contributions are automatically deducted from your pay, you won't be tempted to spend those funds. Some employers even match contributions, which is essentially free money.

But if you withdraw your funds early, you'll typically face consequences. Generally, the IRS allows you to start pulling money out of your 401(k) without penalty starting at age 59 ½, and you're required to start taking withdrawals at age 70 ½.

If you dip into your 401(k) before that age, you'll likely owe both federal income tax and a 10% penalty on the amount that you withdraw. You may be on the hook for state income taxes, too.

It may seem like a really good idea to pull that money out and bring down your debt, but it likely has real, significant, long-term implications.
Lisa Margeson
head of retirement client experience and communications at Bank of America

Long term, taking an early withdrawal also means you "lose one of the advantages, as an early adult, that's on your side when it comes to investing, and that's longevity," says Lisa Margeson, head of retirement client experience and communications at Bank of America.

That's because the earlier you start saving, the more time compound interest has to work for you. With compounding, you earn money over time on both the funds you put into a retirement account, and the growth of your investment, so you're earning returns on your returns.

That means if you invest early and leave your savings alone, over time, the money will snowball and you will have more wealth with less initial investment on your part.

"Near term, it may seem like a really good idea to pull that money out and bring down your debt, but it likely has real, significant, long-term implications," Margeson says.

Why young people use 401(k)s to pay down debt

Younger savers carry more debt than previous generations did at their age, which is causing them to look for alternative ways to pay down their balances. One major reason is student loan debt. Pew Research Center found that the number of households with student loan debt doubled from 1998 to 2016. The median amount of loan debt millennials carried was $19,000, significantly higher than Gen-Xers' balance of $12,800.

But it's not the only factor. Middle class life is now 30% more expensive than it was 20 years ago, according to Alissa Quart, executive director of the Economic Hardship Reporting Project and author of the book, "Squeezed: Why Our Families Can't Afford America."

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All Americans, regardless of age, are feeling the squeeze. Salaries just don't go as far as they once did to cover the necessities. In fact, the average paycheck has the same purchasing power it did 40 years ago, Pew Research found. When adjusted for inflation, the average hourly earnings peaked more than 45 years ago, according to Pew. A $4.03 hourly wage in 1973 had the same purchasing power that $23.68 would last year.

But younger adults may be feeling particularly grim, Merrill's report found: 8 in 10 say it's harder to become financially independent for them than previous generations. And 70% of Baby Boomers agree.

Nearly two-thirds, 60%, of people aged 18 to 34 now believe that "financial success" means being debt-free, as opposed to just 19% who say the definition is being rich, Merrill's survey found.

"Freedom from debt, to some, seems like a low bar of accomplishment, but it's just an elusive goal for many of the early adults today," Margeson says.

Don't miss: Here's why 1 in 3 college-age Americans consider payday loans with interest rates of 400%

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There are 3 ways to pay off student loans—here's how to choose the best one for you
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