Take $$ out of 401 to pay off debt?
It's open enrollment time and we were chatting about our retirement plans. One of my coworkers is planning to take $20K out of his 401A to pay off all debt except his house. He thinks the interest savings by paying off the debt will far outweigh the tax hit for early withdrawal and he'll be able to recoup it by increasing contributions to his retirement (he's 43). I did some math and $20K at 14.99% interest and a minimum payment of $350 per month will take 8 years to pay off with total interest at $15K. Google says it's a 10% tax hit for early withdrawal, so $2000.
Does this make sense? Thoughts from you financial guys?
On paper it sounds like a winner but in reality its a loser.
First you take the 10% hit thats 2000
Then to pay back the loan you have to do it with AFTER TAX money so that means he would have to make an extra 30000 to pay back the loan to have about 20000 in payments.
Then once you figure out the cost of losing the growth of that money in your 401k and the fact that most people that find a way to consolidate their debt wind up back in the same hole almost immediately you realize that your better off just buckling down and paying it off yourself and using it as a learning tool to teach better spending discipline.
He can drastically reduce the cost of the interest on his debt by cutting back on other things and applying it to that debt. That would be a much better way than jerking around his retirement.
I agree with Soonerborn.
Depending on his portfolio holdings, he should be able to average a long term return of 6-10%. If your coworker is 43 and he is planning to retire at 65, that $20k will be worth roughly $45k at retirement. He's giving up $25k in total returns at retirement to save $15k in interest (according to your estimates) over 8 years. Then on top of that, he's going to pay a penalty for the withdrawal and lose the tax advantages of his 401A plan.
It may feel good to pay down debt and increase his future contributions, but it doesn't make mathematical sense. Your friend needs to leave his retirement savings untouched and make other financial adjustments to pay down the debt. Unless the interest on the debt is just massive, you'll usually be better off maxing out a tax-advantaged retirement account first and then shifting your focus to paying down debt.
That makes sense. I just looked up my statement from the last quarter and I averaged a 17% return on my 401A. Not sure how/where he's invested but most of my funds seem to be doing well. I suggested he meet with one of the financial advisors to look at the whole picture.
Maybe I'm reading the question and some of the replies wrong..... Is he taking out an early withdrawal, or is he taking out a LOAN from his 401K against his balance?
I haven't seen it mentioned but I will throw this into the pot as well. The 10% you mention is not a tax, it is an early withdrawal penalty on the money taken out. That money is then also taxed at your current tax rate on your tax return. So if you are at an average tax rate in 2012 of say 30%, you will pay 40% of the money taken out to tax and penalty.
Sounds like OP is talking about the guy wanting to withdraw the money.
That's where the penalties and interest losses come in to play.
A LOAN, on the other hand, seems like a good idea. No penalty and you're paying interest to yourself.
Originally Posted By sparky923:
Sounds like OP is talking about the guy wanting to withdraw the money.
That's where the penalties and interest losses come in to play.
A LOAN, on the other hand, seems like a good idea. No penalty and you're paying interest to yourself.
That's what I was thinking too. Early withdrawals are bad, bad, bad. Loans can potentially be okay, depending on the terms. I'm not a financial guru by any means though.
The term loan didn't come up but I may have assumed he meant withdrawal. I did that several years ago to up our down payment but it was tax and penalty exempt.
it doesn't apply in this case but there are times it's well advantageous to cash in your 401k/IRA
Yes, you pay 10% off the top to the man as a penalty.
BUTTTTTTTTTTTTTTTTTTTTTTTTT
if your income is very low that year (ex. no job, major medical expenses, huge deductions, starting a new business, big depreciation, whatever)
You can get all your money out without paying income tax (or very low rates) (minus the 10%)
considering you didn't pay your regular rate when you put it in (it's pre-tax remember) that means you earned a lot of money for a 10% tax rate. That's quite good.
considering the lowest tax rate out there is 15% and goes up dramatically from there.
And they aren't going down anytime soon ever.
Paying the 10% tax might not be all bad.
Don't just dismiss it out of hand.
Do your own research.
At 43, it would not be wise to spend the savings. IIRC, you could borrow 1/2 of your 401, or $50,000. You would be paying yourself the interest, albeit 3% or so.
There are some who feel that Europe is teetering on the edge, and markets may take a substantial hit. This may be a way to prevent losses. A paltry 3% beats losing 40% or more on a sell-off. YMMV.
Weigh the options, and do your own homework.
Originally Posted By sparky923:
Sounds like OP is talking about the guy wanting to withdraw the money.
That's where the penalties and interest losses come in to play.
A LOAN, on the other hand, seems like a good idea. No penalty and you're paying interest to yourself.
Agreed, sounds like a withdrawal is the topic at hand.
Re. loans: No penalty, except for the fact that your loan is funded by removing your own money from the investment market.
Sure, you pay yourself the piddly interest, but I'd rather pay that interest to a bank to take THEIR money out of the market.
It's not just the 10% penalty - the withdrawal amount is also taxable income on top of his regular income, so that's another 25%+ if he's making decent money.
However, the withdrawal idea is dead in the water if he's talking about the plan where he currently works - you cannot take a from your retirement plan unless reaching retirement age, disability or death - unless the plan has a loan provision which typically allows for borrowing up to half your vested balance or 50K max as someone else mentioned. So a loan is his only option (if available) until he leaves the company.
A retirement plan loan is usually a bad idea, mostly due to the lost gains from the amount not in the markets... but considering our future prospects...
