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Around here, we’re all about getting out of debt. We love hearing stories about folks who are gazelle intense about paying off their debt—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 it means you’re finally debt-free.
One example of gazelle-intensity-gone-wild is using your 401(k) to pay off debt. Listeners call into Dave’s radio show all the time to ask if they should cash out their 401(k)s to pay off their credit cards or even their homes.
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His answer: No way! Dave would only consider it to avoid bankruptcy or foreclosure. Otherwise, your 401(k) is for retirement only!
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.
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.
Good Intentions Gone Wrong
Let’s say you have 15 years left on your mortgage, and the balance stands at just about $115,000. You’re on fire to get out of debt, so you’re thinking of cashing in an old 401(k) that has a balance of $175,000 to pay off your home and finally be debt-free.
Your Taxes and Fees
You might initially think your 401(k) will easily pay the balance and leave you $60,000 to restart your retirement. But, thanks to taxes and fees, it will take all of your retirement savings as well as some cash out of your pocket to pay off your home. After your 25% income tax bill plus the 10% early withdrawal penalty, you’ll have less than $114,000 left to pay off your $115,000 mortgage. So far, this plan has cost you more than $60,000.
Your Lost Retirement Growth
Now you’re debt-free. But you’re probably also over age 40 with zero retirement savings. 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.
But, by starting over now, you’ll reach age 65 with just $567,000. So you decide to roll your house payment into your monthly retirement investing amount. By doing that, you could retire with $1.3 million—about $400,000 shy of what you could have had if you hadn’t cashed out your 401(k).
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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, or to help pay for your kid’s 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, you could increase your monthly mortgage payments by $525, 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.
Find a Solution for Your Challenge
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 stinker, 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 build your nest egg.