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Should you pay off all or part of your debt with your 401(k)?

Perhaps you’ve thought of dipping into your 40l(k) to pay off some or all of your debt. In general, I would almost always say that’s not a good idea, but recently I had a student whose 401(k) was certainly big enough to pay off a large portion of the debt, so it had to be considered.

This person was a student in my program that enables most Americans to be debt-free in two to 10 years — including their mortgage.

In her initial coaching session we determined that she could pay off her debt in 12.24 years, without considering the 401(k). Her income was almost exactly $40,000 annually, with a net take-home income of about $2200 a month. The living expenses, does not include debt payments, were about $850 a month. Her mortgage was $120,000 with a payment of about $900 a month. She also had a student loan of around $20,000 with a payment of $150 a month. As you can imagine, she was pretty much living paycheck to paycheck.

In addition, her mortgage was an adjustable-rate mortgage, which further muddied the waters and was the primary driver of her fear. With the possibility of inflation and rising interest rates in future and not many prospects for increasing her income, she was in a very dangerous place. With a slight upward adjustment of her mortgage interest rate, she might no longer be able to afford their mortgage payment.

With a total of debt owed of about $140,000 and a 401(k) of $60,000, considering her financial situation, you can now see why we began to consider that option.

The first thing we looked at was her previous year’s income tax return to see what kind of deductions she took and what her tax rate was. Then we discussed this year and any possible changes. In 2011 her tax base was 15% with typical deductions for family members and mortgage interest deduction. For this year there would be no other changes.

Our first calculation was simple: how much mortgage interest could we deduct in 2012? With all other deductions being the same and knowing what her income would be, we could easily forecast 2012′s taxes within $100 of the previous year. This was an important calculation to determine what the tax rate would be without touching the 401(k).

Next, we had to determine how much mortgage interest would be paid in 2012. Her mortgage of course was variable-rate, but it did have some caps and some maximum adjustments for certain periods. We also knew that over the next 12 months there probably wouldn’t be a radical increase in interest rates.

(Those two factors point up why adjustable-rate mortgages are dangerous, even without inflation.)

We now knew about what her mortgage interest deduction would be and could forecast the 2012 tax rate and taxes and determined found that her tax situation would be almost exactly as it had been in 2011.

The third step was to determine the actual cost of withdrawing the $60,000 from the 401(k) to pay off her debt. She would have to pay 10% penalty on the $60,000, leaving her $54,000 in her 401(k). Next we have to calculate the changes in her overall tax liability for 2012. Not only will she pay income taxes on the $60,000, her income tax rate almost certainly will increase on her wages of $40,000. I believe this is something most people would fail to consider.

In this case, adding $60,000 to her income, even after the deductions, would increase her tax rate from 15% to 28%. So without taking out the 401(k), she had $40,000 in income with $12,000 in deductions and would have to pay 15% of $28,000 monthly and taxes which is about $4200. If she cashes out the 401(k) she would start out at $100,000 in income for 2012. With just $12,000 in deductions, she would have to pay 28% of $88,000, about $24,640. If we take $24,640 and subtract what her taxes would be without the 401(k), she had an increase of $20,440 plus the $6,000 penalty, for a total cost of $26,440 for cashing out the 401(k), leaving about $33,560 to pay off debt.

The fourth step would be to measure the impact of paying off $33,560 of debt and how much it would save in interest versus the cost of cashing out the 401(k). We should also determine much sooner she could pay off the debt versus what the 401(k) would possibly be worth at that time.

With the 401(k) amount equaling close to 25% of her total debt and considering her budget was extremely tight and she had an adjustable-rate mortgage, you can now see why withdrawing the 401(k) might be a consideration.

We determined that if she paid off $33,560 of debt, she would save about $40,000 in interest and reduce the time it would take to pay off all debt from 12.24 years to about 9.3 years, thereby saving about three years on the path to become debt-free.

But now here comes the tough part: what would be the value of the 401(k) in nine to 12 years? This involves speculation — something I’m not fond of when trying to improve someone’s financial future — specifically with the intent of making her safe and planning for retirement.

Without getting too deeply into it, the average American should not invest retirement funds in the stock market. That’s ridiculous in my opinion; it’s like putting your future on the line in Las Vegas. Knowing that most Americans can be debt-free in a short period time with the proper tools and support, it makes much more sense to pay off your debt in five or even 10 years if that’s what it takes, and then begin to save $2000 or $3000 a month and invest in virtually risk-free annuities.

For this portion of the analysis I chose to take a rather conservative approach and made the simple assumption that she would get at least 5% return on her money within the 401(k) and by simply using the rule 72, the 401(k) would double from $60,000 to $120,000 in 14.4 years.

So in the end in her particular case it was my opinion that she should not use the 401(k) to pay off her debt. I recommended she stay on her current debt-payoff path of 12.24 years and work on creating stability. I plan to continue coaching her into higher credit scores and refinance her adjustable-rate mortgage into a fixed rate.

If you are considering tapping into your 401(k) to reduce your debt, my system is probably a better way to go. There is no charge for my system; I provide it absolutely free. To find out more, go to my website, www.DaveBurke.me.

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