My Answer to Reader: Do the Math and Leave Your 401(k) Alone

by Joe Plemon on May 9, 2011

A reader recently wrote the following comment on my post 4 Reasons You Should Not Use Your 401k to Pay Off Your Credit Card so I have pasted both the comment and my answer, hoping that you readers will help scrutinize my logic and point out any flaws you may notice. Obviously, I made some assumptions (which didn’t seem unrealistic), but I saw no other way to run these numbers without doing so.

Question from reader

Ok, so what if I don’t want to take out a loan on my 401K? I already practice the snowball effect and we give the minimum amount to our 401k – essentially whatever is being matched by our jobs. We have about $66,000 in revolving CC debt. We could use our 401K to eliminate that debt and be left essentially with only our mortgage payments and my school loan. With all this debt eliminated we could max out our 401k’s going forward at 15% each (we only give 5% now). It would also help come tax time as our taxable income would be lowered considerably if we give the 15%. We would also be able to give additional money to the IRA allowing our 401K to grow at a much more aggressive rate while being virtually debt free. I also realize if we take that much out we will likely be penalized at about $30,000 for this year. My question is, couldn’t this all be offset in some twisted way to work in our favor while getting virtually debt free? I don’t want to borrow, I just want to drain it and use it pay off the debt altogether. The CC debt was created due to losing my job and being out of work for an extended period. We are followers of Dave Ramsey and have been chopping away slowly but would love to start really charging after our retirement but at 5% per person it’s not really getting where we need it as quickly as we’d like. I just feel like if we can get rid of all our revolving debt we could begin really growing our 401K at break neck speed. Thoughts?
joeplemon May 4, 2011 at 10:36 am [edit]

My response

Let’s run some numbers based on the following assumptions:
1. You would need to withdraw $100,000 from your 401k to pay off the $66k in credit card debt.
2. You are 30 years from retirement.
3. Your combined annual income is $50,000, which means you are contributing $2500 annually (5%) to your 401k plans and receiving a 100% match for those contributions, effectively giving you $5000 annual contributions.
4. Over that 30 year period, your investments will earn an 8% average annual return.

Based on these assumptions,

If you continue what you are doing, your retirement nest egg will be about $1.7 million in 30 years. However, if you draw out the $100,000 and start anew with 15% investments (earning 100% match on your first 5% and zero match on the next 10% contribution), you would be effectively investing $10,000 annually. With an 8% return, your nest egg would be worth $1.2 million in 30 years, meaning that withdrawing $100K today is a $500,000 mistake.

It is actually more than that because you WILL eventually get that credit card debt paid off and bump up your investment contributions, thus increasing that $1.7 million you would have if you only contribute the 5% for the next 30 years. For example, if you paid off the credit card debt in five years and bumped your retirement investments to 15% at that time, (although I would recommend a big emergency fund before increasing your investments) your nest egg in 30 years would be about $2.1 million…$900,000 more than if you pulled the $100,000 from your 401k today.

I realize that the money in that 401k is tempting, but I urge you to leave it alone. One of you might consider a second job just long enough to pay off that credit card debt but even if you don’t get it paid down for a long time, your retirement will be more solvent by leaving your contributions in the fund instead of tapping what you have worked so hard to build up.

I also realize that I made some huge assumptions, but the results would be very similar even if the specifics changed considerably.

Please write back. Feel free to ask questions and let me know if what I have said makes sense.

OK readers — your turn. What advice would you offer? In what ways do you agree with me? How do you disagree?

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