401(k) loan for debt pay down?

Dear Pete

Say you’re a 43-year-old guy with a family of five who had made a lot of stupid financial decisions over the years and accumulated a boatload of debt ---- not that I would know anyone in this situation, of course…. (HA!)

My question is: WHAT good is retirement savings if it is stacked against all that stupid debt you’ve got to find a way to pay off?

Isn’t it better just to take all your retirement savings (if it’s accessible to you), pay off your debts and start over on retirement savings (or else just work for the rest of your able life)?

William

Hey William,

I understand you are in a place where you feel like you've run out of options. A lot of people are right there with you. You see a 401(k) or Traditional IRA loan as a saving light. So let's run through it and see what would actually happen if you used this type of loan to pay off your debt.

In order to do the math we'll have to give your debt, your retirement account, and your income, numbers. These are just shots in the dark, don't get too caught up in them, they're just examples.

Let's say these are you numbers:

Income: $60,000

Debt: $25,000

Retirement account: $25,000

So you decide to withdraw $25,000 from your retirement account to pay off your $25,000 credit card debt...

"If your retirement savings is in a 401(k) or Traditional IRA, then you haven’t paid any taxes on the money which funded the account. You must pay taxes on it at some point, and according to the IRS, that some point is when you make a withdrawal. The required Federal tax withholding upon making a $25,000 withdrawal is $5,000 (20%), plus the additional $1,250 of federal taxes because you are in the 25% tax bracket, plus the state withholding of $850, and plus the $2,500 penalty for taking an early withdrawal (before age 59 1/2). So of the $25,000 worth of retirement investments you started with, you will only get to use $15,400 to pay off your debts. You will receive less than 62% of your retirement account balance." (courtesy of the Indy Star)

Let me reiterate, you will only actually receive around 62% of the amount you withdraw.

There are only so many ways I can say loans on your retirement account are bad, so let me further prove this point, not with words, but with numbers. Well, alright, some words, but you get my meaning.

"If you were to leave your retirement account alone, and it were to grow at an average 8% rate of return over the next 23 years until you reached age 66, you’d have over $140,000 in your retirement account, and that’s without adding another penny to the account. Upon wiping-out your retirement fund down to $0, you would then have to invest roughly $320 per month for the next 18 years to match the amount of money you would have had if you didn’t wipeout your retirement account now. By the way, $140,000 isn’t enough money to retire either today, nor 18 years from now nor 23 years from now. So your $320 per month investments would need to be in addition to your normal retirement account contributions." (courtesy of the Indy Star)

But I won't just leave you with a negative answer, the positive is what happens when you use your income to pay off your debt.

"If the interest rate on your debt is 18% and you pay $625 (the approximate minimum payment on $25,000) per month until the debt is paid off, it would take you 61 months to payoff the debt. You will have paid $13,465.57 in interest over the five(ish) year period. Under this scenario, your net worth increases the entire payback period, opposed to taking a massive hit if you were to throw away your retirement savings. Once you vanquish your debt, you'll be able to put the $625 per month toward retirement." (courtesy of the Indy Star)

Paying off debt with your income is absolutely the harder path, but since you are in a place where you are asking questions about best practices William, this is the answer. It does seem like cashing out a savings account to wipe out debt and essentially "start over" is a good idea, but it doesn't work out that way. Your end goal is to get out of debt and continue to increase your retirement savings, but even more valuable than that is any good financial habits you can develop in the process.

Read the rest of my Indy Star column here.