During the recent times of economic upheaval many people are returning to a more common sense way of dealing with their finances. Over the past few decades, the American public has given in to the “drunken sailor” philosophy of personal finance and taken on unprecedented levels of debt that has come back to bite us in the behind.
Recent stats show that more people are waking up from their drunken sailor hangover and starting to pay down their debts. As a country we’ve finally started to realize that the party doesn’t last forever and that the only way to keep from going under financially (and to secure a future) is to make sure you and your family are debt free.
So, many people are now trying everything they can to find a way to pay off those stubborn debts. One of the questions I get most frequently is “Should I use some or all of my 401k money to pay down my debts?”
At first glance this might seem like a good idea. You tell yourself “I’ve got $20,000 in my 401k and I owe $20,000 in credit card and other debts. I can be debt free if I just use that money that’s just sitting there doing nothing. Besides, the stock market is not growing that money anyway right now, paying down debt and not having to pay all that interest would be a good thing, right?”
There’s something about being in a lot of debt, especially if you are desperate, that keeps you from thinking clearly. Not only does the drunken sailor theme apply to getting into debt, it also applies to getting out. A drunken sailor doesn’t think about consequences, he thinks about what’s fun now, banishing future consequences from his mind. This, by the way, is how Johnny Marine ends up in the gutter.
First, there are immediate consequences to cashing out 401k money. Just because you have $20K in the account doesn’t mean you’ll get $20K if you cash out. When you take cash out of a 401k, IRA, etc., you have to pay taxes on that money at your normal tax rate. So if you are in the 25% tax bracket (middle class), then 25% of your $20,000 automatically comes off the top. Now you have $15,000 to pay off your debts.
But wait! Retirement plan laws dictate that if you withdraw money before retirement you have to pay a 10% penalty ($20,000 x 10%= $2,000) on top of the taxes you already paid. Now you have just $13,000 to pay off that $20,000 of debt you have.
The next thing that any inebriated deckhand should consider while in his debt induced stupor is that when one takes money out of his retirement plan, he has sabotaged his future security to alleviate problems in the present. If that money is taken out it won’t stay there and grow as the market improves over time. So not only did he lose 35% of his money by withdrawing, he actually lost almost $150,000 of future earnings ($20,000 x 10% x 20 years). So now because he wasn’t thinking clearly, over time our inebriated friend has cost himself $150,000 to fix a $20,000 problem and he is still $7,000 in debt. This is the point where he forms a right angle with his thumb and forefinger and raises it to his forehead, he is officially a loser financially.
If you are the drunken sailor and have awakened with a debt hangover and a sharpie moustache courtesy of your friends, don’t compound your problems by taking funds from your retirement accounts, EVER! As you’ve seen, the math just doesn’t work and just as important, it doesn’t change the habits that got you into debt in the first place. The best things you can do are:
- Stop adding new debt, period. Cut up the cards and don’t take out any more loans. Quit drinking the debt cocktails.
- Put together a plan to pay off your debts.
- Get super focused and get those debts paid off
If you follow these 3 simple steps you can get out of debt and never experience the “drunken sailor” effect again (at least not with your money anyway).
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