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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{ 15 comments… read them below or add one }

optionsdude May 9, 2011 at 8:18 am

I am assuming that your math is correct, so based upon that, I would have to agree with you. However, is a 401(k) loan an option for this reader? He would only have to borrow $66,000 and could immediately begin taking the money that was spent on credit cards and apply it toward increasing 401(k) contributions while paying off the loan. I wonder what impact that would have? It would seem that the negative compounding of high interest CC debt versus the lower positive compounding of the 401(k) would virtually offset. Just wondering out loud.

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joeplemon May 9, 2011 at 8:59 am

optionsdude,
Good thought. Borrowing against the 401k sounds better than cashing it out…and could be a good plan depending on the interest currently being paid on the credit cards. Paying less interest is a good thing, but borrowing on a 401k brings on added risk: if one loses one’s job or changes job or dies before paying the loan back, it becomes due in 60 days or else is charged as an early withdrawal (with the 10% penalty and taxes). Also, some plans do not allow you to contribute to your 401k until the loan is completely repaid, which means that our reader would lose the free match until he could start contributing again. Also, even if the numbers work out, I just don’t like the mindset of borrowing against a retirement fund. Doing so once could lead to doing so again. I think the best plan is to tackle the credit card debt with a vengeance (second job, sell a car, etc.) and get it out of their lives as quickly as possible.

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optionsdude May 9, 2011 at 9:35 am

I must say that often the tendency that led to the CC debt in the first place continues even after consolidation loans or other types of “repayment” plans. Ultimately it is better to adjust one’s lifestyle than liabilities.

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joeplemon May 9, 2011 at 10:50 am

Optionsdude,
The old adage, “You can’t borrow your way out of debt.” is still a good one. Like you said, adjusting one’s lifestyle is ultimately better.

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joeplemon May 10, 2011 at 12:07 pm

Jenna,
Yes. Early distribution will cost 10% penalty. In addition, all taxes that have previously been deferred come due (another 20% or so). This is why the reader said, “I also realize if we take that much out we will likely be penalized at about $30,000 for this year. ” It is also why I assumed they would need to withdraw $100,000 in order to pay off $66,000 in credit card debt ($100,000 less 30% for taxes and penalty = $70,000).

Does this make sense?

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Margaret May 11, 2011 at 9:00 pm

How do you calculate the rate of return on the example of the couple contributing $2500 per year, with $2500 company match at 8%.

Using excel FV function =FV(8%,30,-5000), I come up with $516K. What are I doing wrong in my math?

Margaret

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joeplemon May 12, 2011 at 7:46 am

Margaret,
I think you are referring to my calculation of what would happen if this couple continues doing what they are doing. You didn’t do anything wrong with your math, but if they continue doing what they are doing, the PV (present value) is $100,000 because they didn’t tap their 401k. I used PV of $100,000 and monthly contributions of $417 (5000 divided by 12) for 360 months at 8% return to arrive at my $1.7 million.

The difference in our numbers is that I used the PV of $100,000 and compounded the interest monthly instead of annually. Does this make sense?

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Margaret May 12, 2011 at 8:31 am

I understand.. the big differnt between 1.7M and my calculation of $516k is because of the $100k opening amount. Which adds a lot to wight to your argument. The bulk of the earnings over the 30 years is from the initial 100K investment, and less from the contributions each month.

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joeplemon May 12, 2011 at 8:48 am

Margaret,
Exactly. In fact, you said it better than I did. The real “penalty” of drawing one’s 401k funds out prematurely is that they are no longer working for you. It is nearly impossible, once those funds are gone, to contribute enough to make up for that withdrawal.

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Margaret May 12, 2011 at 9:11 am

sorry for my spelling errors. What I was trying to say is that roughly 2/3rds of the proceeds in the $1.7M figure come from the initial $100K and compounded interest over time. This is why your argument to avoid removing the initial $100K is so powerful.
I’m dealing with my own potential disaster and trying to analyze if bankruptcy (with almost no $401K contribution) is better for me (long term) than using my 401K to pay down my upside down mortgage. (Will my 401K be stronger longer term if I declare bankruptcy and do not contribute for 5 years, or if pay down mortgage, sell house, and contribute at a fairly high rate for the next 5 years). Unfortunately, I’m not very far aware from retirement age. Thanks! this is very helpful.

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Boyd Spranger June 5, 2011 at 3:02 pm

Thanks for a really interesting read, learn quite a few tips here, trying hard to improve my credit , i did a consumer proposal 7 years ago and just now i am starting to rebuild my credit slowly but surely and trying to avoid that credit card trap.

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Joe Morgan June 22, 2011 at 7:47 am

The taxes and lost effect of compounding while that money is no longer invested are bad enough, but for me the prospect of losing my job and being on the hook for paying that loan back is the biggest reason not to take a 401k loan now.

With unemployment solidly near 10%, and likely to stay that way for the next few years I’d rather find some other way to mitigate the credit card rates… besides, if I lost my job, it’d be a lot easier to negotiate that credit debt down than to pay back the 401k loan!

Still, I’ve seen money management “experts” argue that 401k loans are the best thing going now (http://simpledebtfreefinance.com/dumb-money-tip-from-smartmoney-mag) , and they’re right -up to a point. They’re great from a purely mathematical point, comparing just the interest rates. But they ignore all these other factors..

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joeplemon June 22, 2011 at 11:24 am

@Joe Morgan,
Exactly…too much risk involved in taking out that 401k loan. The one who takes it and subsequently loses his job has dug himself a deep hole: he needs to be making payments from a non-existent income stream. Another risk possibility is death. Although not as likely as unemployment, it could put the widow or widower in a real crisis…trying to make loan payments while grieving the loss of a spouse. It would be better to cope with CC debt than 401k loan payback in either instance…like you said so well, “if I lost my job, it’d be a lot easier to negotiate that credit debt down than to pay back the 401k loan!”

It seems that many of these mathematical experts who recommend 401k loans don’t know how to factor risk (or common sense) into their math.

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Raul November 9, 2011 at 7:58 pm

I completely agree that taking out money from 401K to payoff CC debt is financially disastrous in long run.
But, if you consider effect of money I will save in CC interest(which currently are close to 20% on all my cards), the calculation might not be that off. I would like to present a scenario here. It will be great if you can help me with running the numbers.
CC debt – $30,000
Average monthly amount paid for interest charges only – $500
Total minimum monthly payments – $1000
Current 401K value – $20,000
Age – 30
was in graduate school for last 2.5 years and did not make any contributions during that time. I got a job now and plan to start making contributions soon. I have few questions:
1. Considering that I don’t have huge investment in 401K yet, I can use $12,000 (after penalties) that I will receive and payoff few high interest CC. That will reduce my interest charge and monthly payment by almost 40%. I can use that money (around $600 per month) to max out my contributions with new job. Did I miss something here?
2. Because I don’t have that much invested in 401K anyway, do you think my impact will not be that severe over my lifespan (as in example shown $500,000 loss).

My new job is paying me enough money to keep my lifestyle and payoff debt in 3 years. I don’t use my cards anymore. But I just don’t like the idea that I am paying $500 a month to CC banks!

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joeplemon November 22, 2011 at 11:23 am

Raul,
I love it that you are no longer using credit cards. And I don’t blame you one bit for hating to pay all of that interest. I ran the numbers on two scenarios:

1. Leave 401k alone and use your $1000/month to get the debt paid for in 3 years. I assume you are putting nothing into your 401k for those three years, then invest $1000/month (the amount you are using to pay off your credit card debt) for the next 32 years — when you will be 65.

2. Withdraw your 401k, use the $12k you net after taxes and penalties to reduce the credit card debt, invest $600/month for three years and then invest $1000/month for the next 32 years.

It turns out your nest egg for both scenarios would be about $2.1 million. So which should you do? Well, as you know, I don’t like cashing out a 401k. It puts you $20,000 behind where you once were, with the pressure to get caught up. Yes, you could do it. But I would rather see you leave that 401k alone and use that $500 month credit card interest as a motivator to pay down the cards ASAP. You said that your new job allows you to keep your lifestyle and pay off your debt in 3 years. My question is this: how quickly could you pay it off if you were to make some serious sacrifices in your lifestyle? If, for example, you could carve out another $500/month, even if it meant a part time job for a while, you could pay all your credit card debt off in only 24 months. Also, if your credit rating is good, you should look into a zero interest transfer.

I wish you the best at attacking this debt and your future investments. You ask great questions and I am confident you will make solid decisions.

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