During the last few years of economic upheaval, some people have begin to return to a more sensible way of dealing with their financial situation. The last few decades have seen the American public give themselves over to the “anything goes” mentality of personal finance by taking on unprecedented levels of debt, which has come back to kick them in the tail over the last few years.
Lately though, some stats have been showing that more and more of us have finally started to wake up from our “anything goes” hangover and have begun to pay down our debts substantially. Many of us have started to realize that “anything goes” can’t last forever and that the only way to a secure future (and a secure present) is to start moving toward debt freedom.
Many Americans have now decided it’s time to do everything they can to pay off those stubborn debts that have been dragging them down for so long.
Because of that, one of the more frequent questions I encounter is “should I use money from my 401k (or IRA) to pay down my debts?”
At first blush that seems like it could be a good idea. After all, that money is just sitting there idle. You start telling yourself “I’ve got $20,000 in my 401k and I owe $20,000 in debt. If I just take that money out I can pay off my debt really quickly and be totally debt free. Besides, my investments in that account have gone nowhere over the past few years, paying off my debt and avoiding all that interest would be the smart thing to do, right?”
There’s something about being deep in debt, and desperate to get out, that can keep you from thinking clearly and making good decisions. Just because “anything goes” got you into debt doesn’t mean you should do just anything to get yourself out of it. Not thinking much about future consequences is what got you into debt in the first place but it surely won’t get you out.
First, there are immediate consequences to cashing out some or all of your 401k or IRA. Just because you have $20,000 in the account doesn’t mean that’s what you’ll be able to get when you cash out early (anytime before age 59 ½).
When you take cash out of a retirement account, you end up having to take out taxes at your normal rate when you withdraw it. Let’s say your rate is 25%. When you make that $20,000 withdrawal, a cool $5,000 goes to pay taxes (The gub’ment do take a bite, don’t she). Now you have only $15,000 to pay off your $20,000 in debt.
But hold on there buddy, that ain’t all. Withdrawing that money early also means you have to pay a 10% penalty ($20,000 x 10%= $2,000) on top of the taxes already paid. Now you only have $13,000 to pay off your $20,000 debt.
Wait, it gets even better. When you subscribe to the “anything goes” mentality of not using your brain when it comes to money, you end up sabotaging your future too. Because when you take that money out of retirement accounts, it’s not allowed to sit and grow over time as investments are wont to do. So not only do you end up losing 35% of your hard earned money to taxes and penalties by withdrawing it early, you actually lose almost $150,000 of future investment earnings ($20,000 x 10% x 20 years).
Now, because of the ubiquitous “anything goes” mentality, everything went. Because you didn’t consider the future consequences of your present actions, you end up costing yourself $150,000 to fix a $20,000 problem and you’re still $7,000 in debt.
It’s now time to form a right angle with your thumb and forefinger and raise it to your forehead, you have officially become a loser with your money.
So if you are one of the millions of “anything goes” people who are now waking up from the party with a debt hangover and a Mike Tyson tattoo on your face, please, don’t compound your problems by taking funds out of your retirement accounts, EVER.
As you can see, the math doesn’t work, and more importantly, it doesn’t change the behavior that got you there in the first place.
The things you can do are:
- Stop adding new debt, PERIOD. Cut up the credit cards and don’t take out any more loans.
- Put together a plan to pay off your debts.
- Get super focused and work that plan.
If you follow these three simple steps you can get completely out of debt and never have to worry about a debt hangover ever again.