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Yikes: 1 in 4 millennials raiding 401(k)s early to pay down debt

Some millennials tap 401(k)s to pay down debt
  • A quarter of adults under age 34 are withdrawing savings from their 401(k) plans to pay down credit card and student loan debt.
  • Fully 60 percent of today's young adults define "financial success" as being debt-free, as opposed to 19 percent who believe it's being rich.
  • Withdrawing funds from a 401(k) comes with heavy tax penalties and can set young savers behind on their retirement goals.

When her husband asked for her signature to withdraw the $11,000 in his 401(k) to pay off credit card debt and a medical bill, Marissa Sanders, 30, tried to talk him out of it. Sanders, who runs a financial advice blog, tried to explain the importance of compounding interest over future decades, but her husband decided against the advice.

"I didn't know what to do, really, he was intent on taking it out," Sanders said.

For a generation often defined by unprecedented levels of debt, the idea of financial independence has become so important that one in four young adults with 401(k)s are choosing to drain their retirement savings to pay down loans, according to a new report from Merrill Lynch and Age Wave. The top reasons for adults under the age of 34 tapping their 401(k)s? Paying off credit card and student loan debt, the survey found.

Tax penalties and long-term consequences

The decision to raid your retirement savings can come with long-term consequences. Most financial advisers consider it a cardinal sin to withdraw funds early from your 401(k), as it borrows against your future wealth and comes with heavy tax penalties. Experts feel that the last-resort option can be avoided by coordinating an emergency fund, a Roth IRA and other, better forms of borrowing.

"Many [millennials] will not explore all options while things are still manageable," said Mark Struthers, financial adviser at Sona Financial. "They wait until things are desperate and options are few. When things are bad, it is easy to put off making a plan."

Any amount withdrawn early from a 401(k) is subject to a 10 percent IRS penalty. Because 401(k) contributions are made with pre-tax dollars, the withdrawal will be taxed as extra income during tax season.

The setback also means workers have less time to raise money to retire, or will have to settle for a lower quality of life in retirement. Sanders, who personally set a $2 million retirement goal, already feels behind on her progress. "I'm worried that we'll have to work much longer," Sanders said. She hopes to save enough to live comfortably and also go traveling.

"It's very, very expensive money, so you might be better off going to mom and dad for a loan," said Chris Chen, financial adviser at Insight Financial Strategists.

Why are Americans forced to work longer?

$1.6 trillion in student loan debt 

Only 68 percent of 20-somethings are even eligible to contribute to a 401(k) plan, according to the Center for Retirement Research at Boston College. While people in their 20s and 30s today are more educated, more diverse and more technologically savvy than their parents and grandparents, they're also carrying exorbitantly high levels of debt at a time when wages are stagnant and the cost of living is rising.

Americans collectively carry about $1.6 trillion in student loan debt today. They're graduating with nearly $37,000 in student loan debt and paying monthly installments of $371 for 10 years, according to the Merrill Lynch report. They're also averaging $3,700 in credit card debt.

"That debt has a ripple effect," said Lisa Margeson, head of retirement client experience and communications at Bank of America, parent of Merrill Lynch.

Anxiety around financial independence

Debt is making "adulthood" prove so elusive for many adults that financial independence is increasingly becoming the top priority. The study found that 60 percent of today's young adults define "financial success" as being debt-free, as opposed to 19 percent who equate success with being rich.

It's understandable when you consider how debt is reshaping priorities: Some early adults are assessing whether they can afford to have children. Fewer adults are buying homes than they were just 10 years ago. Still others with debt are contributing only half the amount of those without debt into their 401(k)s, Merrill Lynch reported.

Meanwhile, 75 percent of young adults defined success as financial independence from their parents. Nearly 60 percent of early adults said they could not afford to get by without financial support from their parents, and 70 percent said they received some form of help in the last year.

While both parents and children are happy for the intergenerational support, children are wary of over relying on their parents, especially as they get older past 25, as it can add to their anxiety that they are falling behind.

"That's sort of the target for when they'll feel like an adult," Bank of America's Margeson said. 

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