Around here, we’re all about getting out of debt. And we love hearing stories from folks who are gazelle intense about paying off their mortgage—sweating, selling and sacrificing to become debt-free.
But, you may be surprised to learn there are limits to gazelle intensity. Some sacrifices are simply not worth the payoff, even when they could help you finally become debt-free.
One example of gazelle-intensity-gone-wild is using your 401(k) to pay off debt. Listeners call into The Dave Ramsey Show all the time asking if they should cash out their 401(k)s to pay off their credit cards or even their homes.
Dave’s answer: No way! The only time he might say to consider it is if it’s to avoid bankruptcy or foreclosure. Otherwise, your 401(k) is for retirement and that’s it!
So, why is Dave so firm about leaving your 401(k) alone? For starters, whatever amount you take out of your nest egg before age 59 1/2 is going to cost you a 10% penalty plus your tax rate. That means you’ll never see 30–40% of the funds you planned to take out. And if you’re in a higher income tax bracket, that number is closer to 50%. No thanks!
There are limits to gazelle intensity. Never cash out a 401(k) to pay off debt unless it’s the only way you can avoid bankruptcy or foreclosure.
Why Do People Cash Out Their 401(k)s Before Retirement?
Even with all the taxes and fees that come with early 401(k) withdrawals, many folks are not deterred from raiding their nest eggs. A recent Fidelity study found that a third of investors have cashed out all or a portion of their 401(k) before reaching retirement, often after changing jobs.(1)
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Why are so many people willing to flush a huge chunk of their retirement savings down the drain? The most common reasons include paying off debt and covering a financial emergency or unplanned major expenses.(2)
That’s why it’s so important to finish Baby Step 3 and have a fully funded emergency fund of three to six months of expenses in place before you start investing. Stuff happens. It’s going to rain. And when it does, you need to be ready. Don’t wait until Murphy shows up in your life to realize that your 401(k) is a horrible substitute for an emergency fund.
Workers in their 40s are particularly vulnerable to falling into the early withdrawal trap. Burdened with mortgages, debt payments, and stress over how they’re going to pay for their kids’ college funds, they’re the group most likely to bust into their 401(k) accounts.(3)
The good news is you don’t have to go through this alone. Talk with an investing professional who can help you come up with a plan to save for retirement, fund your kids’ college, and pay off your mortgage faster—all at the same time. They’ll also help you stay focused and avoid potential pitfalls as you work toward your retirement goals.
Whatever you do, don’t make the mistake of cashing out your 401(k)—not even to pay off the mortgage or other debts. It’s a mistake that could potentially cost you hundreds of thousands of dollars in the long run.
Like Dave says: "Stay away from microwaves; they don’t cook well. Crock-Pots work better." We’re in the Crock-Pot business. To see why cashing out a 401(k) isn’t worth it, let’s take a look at how it could play out in a real-life scenario.
What Happens When You Cash Out Your 401(k)?
Let’s say you’re one of the many Americans who initially got a 30-year mortgage instead of a 15-year. You’re halfway through the term, so you have 15 years left on your mortgage, and the balance stands at just about $120,000.
Since getting that 30-year mortgage, you’ve taken control of your money and you’re on fire to get out of debt. So, you’re considering cashing in an old 401(k) that has a balance of $175,000 to pay off your home and finally be debt-free.
You might initially think your 401(k) will easily pay the balance and leave you with $55,000 to restart your retirement. But, thanks to those taxes and fees we talked about earlier, it will take all of your retirement savings as well as some cash out of your pocket to pay off your home.
After your 24% income tax bill plus the 10% early withdrawal penalty, you’ll have less than $116,000 left to pay off your $120,000 mortgage. So far, this plan has cost you more than $59,500. That’s like borrowing money at 34% interest. Mathematically, it just doesn’t make any sense.
The True Cost of Cashing Out Your 401(k)
Let’s say you did it. You cashed out your 401(k), you paid off your house, and now you’re debt-free. The thing is, you’re also probably over age 40 with zero retirement savings. That’s not good! And, by cashing out all your 401(k) savings, you gave up years of potential compound growth. Ouch.
If you’d rolled your $175,000 nest egg into an IRA and kept contributing the same amount for the next 20 years, you could have ended up with $1.7 million by age 65. Even if you rolled the nest egg over and didn’t add a single penny, you still might have ended up with more than $1 million at retirement.
But, by starting over now—say, at age 45—you’ll reach age 65 with just $567,000. You realize that’s not going to be enough, so you decide to roll your house payment into your monthly retirement investing amount. By doing that, you could retire with close to $1.3 million—about $400,000 shy of what you could have had if you hadn’t cashed out your 401(k).
But what, if anything, have you gained? Sure, you’re debt-free, but your lifestyle didn’t improve at all. You couldn’t use your extra cash for vacations, to help pay for your kids’ college, or even to give generously when you saw a need. You had to use it to play catch-up on your retirement—or end up with a severely underfunded nest egg.
A Better Solution
So how can you achieve your dream of becoming debt-free without burning through your retirement account? Since you have no other debt, there are several ways you could pay off that mortgage early:
- Increase your monthly mortgage payments by $500, treating your 30-year loan like a 15-year loan. You’ll be debt-free six years sooner! And, if you then add your house payment to your monthly retirement contribution, you could retire at age 65 with a paid-for home and nearly $2 million in your nest egg.
- Make an extra house payment each quarter. By making an additional payment of $950 four times a year, you’ll be free of house payments almost five years sooner and still have time to keep building your nest egg.
- Downsize your home. This would be a huge step, but if you’re willing to sell your larger home and use the profits to buy a smaller, less expensive home with a smaller mortgage, you could get out of debt even faster. You might even be able to pay cash for your new home and be out of debt altogether!
If you need help with a mortgage, we recommend you contact Churchill Mortgage.
Talk With a Pro
Everyone’s situation is different, but for most people, sacrificing the future security your 401(k) provides is never a good idea—even for a goal like becoming debt-free.
Some folks will argue that their 401(k)s are simply no good. Their investments aren’t growing, so they believe it would be better to use the money to pay off their home rather than to keep it in their retirement account.
If you feel that way, talk with an investing professional you trust to see if it really is an inferior plan or if you can make some simple changes to start seeing real results.
Even if your old 401(k) is truly a dud, don’t cash it out. Roll it over into an IRA or Roth IRA where you and your advisor can choose better mutual funds to help build your nest egg.