Should I Use My Old 401K to Pay Off Debt?
TAKING MONEY OUT OF YOUR 401K…ARE THERE CONSEQUENCES?
The short answer is yes. If you’re contributing money to your 401K pre-tax, then all that money will eventually come out of the 401K as a taxable distribution. This means that you will have to pay ordinary income tax at whatever your tax bracket is for that year. If you are under the age of 59.5, then there is typically a 10% penalty that you will have to pay for taking the 401K money out early. If you live in a state that has state income tax, then there may be additional taxes you have to pay on the money taken out of your 401K. There are several exceptions depending on the situation, but for purposes of this episode, I will discuss the consequences as if no exceptions apply.
PAYING OFF DEBT WITH 401K MONEY
Let’s get into the numbers. Maybe you have $20,000 in a 401K right now and you have credit card debt with a 22% interest rate. Your first thought may be, let me take the $20,000 and get rid of this high interest credit card debt. Chances are you are paying more interest on your credit card debt than what you are gaining with the $20,000 invested in your 401K. While this may seem like the way to go at first, there is a lot more to consider. Let’s say you fall under the 22% tax bracket. If you take the $20,000 out of your 401K, you will have to pay 22% ordinary income tax on that withdrawal. If you’re under the age of 59.5, there will be an additional 10% tax penalty on that $20,000 withdrawal – now we’re up to 32% you have to pay in taxes. I’ll be conservative for this example and say that you live in a state with 5% state income tax – now you’re up to paying 37% in taxes. Once you deduct the taxes from that $20,000 you’re down to just $12,600. 37% is obviously higher than the 22% interest rate you’re paying on the credit card debt. Now, I realize that you pay the credit card debt for a longer period of time, and this 37% tax hit to your $20,000 withdrawal is only a one-time hit. But you have to consider the fact that you are losing a substantial amount of money all at once.
You have some different options as far as paying the taxes on the $20,000 401K withdrawal. You do have the option of withholding taxes, but some 401K administrators might automatically withhold the 20% standard rate. If you are able to get the full $20K without paying taxes initially, keep in mind that the this will be added to your taxable income, which could potentially put you into a higher tax bracket.
TIME VALUE OF MONEY
For those of you not familiar with the time value of money, it basically means that $1 today is worth more than the same $1 tomorrow. The reason for that is because prices continue to go up and inflation keeps eating away at the purchasing power of that dollar. So while today you may be able to buy a certain amount of goods or services with that dollar, you will not be able to purchase the same amount with that dollar 10 years from now. I’m sure you’ve noticed that prices continue to rise – groceries, gas, etc. Slowly but surely, your $1 keeps losing its purchasing power. Let’s go back to the example with the $20,000 from the 401K. Suppose you kept that $20K invested in the 401K or rolled it over to an IRA…what do you think will happen? Well, if you kept that $20K investment for a 30 year period without adding any money to it, and your investment averaged a 7% return over this period, that $20K will be worth $152,245! Now imagine if you were adding money to that investment regularly. Let’s make this even better and assume that your employer is matching your 401K contribution, just think about how much money you could have over that 30 year time frame! So, taking that $20,000 out today to pay off your credit cards could cost you A LOT in the long term.
CERTIFIED FINANCIAL PLANNER™ PROFESSIONAL
Before you decide to take money out of your 401K, there are several factors you need to be aware of and fully understand. This is when hiring a Certified Financial Planner™ Professional is incredibly important and helpful. Having someone who understands tax laws, compounding interest, the time value of money, and can apply his/her skills and experience to your situation is absolutely priceless. While taking money out of your 401K to pay credit card debt is likely not the best option, it is important to have a plan to get out of debt! This is another area that a Certified Financial Planner™ Professional can work with you on. In the meantime, be sure to check out the resource area of the show notes section where I list some things you can start doing now to help you get out of debt. Remember, even slow progress is still progress. Acknowledge your efforts and celebrate your wins. I would be happy to help you Build A Better Financial Future!
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