Paying of Debt with 401K

[LRZ]

Hello everyone,

I've been reading through a lot of the discussions on here about cashing in on your 401K to pay off debt. What I've realized is everyone's situation is different, so, I figured I would put down what mine is and ask for your input. So here it goes...

I'm 34, who unfortunately had very foolish spending habits and fairly recently realized the importance of saving for retirement. So in the last 2 years or so, I've managed to put up about $10,400 in a simple IRA. I went through a divorce a few years back, and unfortunately was left with a lot of debt that my ex incurred. She was supposed to clear them, but she didn't, so have had to take care of them myself. Because of this, my credit is pretty bad, mid 600's. I'm working for a company who, beginning Jan 1, 2014, will be switching our simple IRA to a 401(K). I've increased my contributions to 9% of my income (less than $50K/yr base salary) to go towards my 401(K), and increase by 1% every year until it hits 12%. A questionnaire determined I was an Aggressive to Growth kind of an investor, so have elected for my 401(K) contributions to reflect that. My company matches up to 3%, plus another 3% of my income per year as part of a Safe Harbor plan. In addition to all this, I also have a life insurance with Northwestern Mutual. I'm not completely familiar with the lingo, but I have immediate death benefit, and a separate one which I pay about $200/month. This one is so by the time I retire, I have approximately $200,000 that I can take out for retirement.

All that being said, here's the fun part...my debt! I have credit card debt of about $4500 (interest rate at 26%), and store card debt of about $2200 (interest rate at 22%), and a horrible payday loan of about $1000 (God only knows what the interest rate on that is). On the flip side, I don't have a car payment, I paid off my college loans about 2 years ago, take public transportation so as to save on gas money, and have made my living arrangements to where I'm paying about $300/month. While this may not seem like a lot to some, it is hard for me because by the time everything is said and done, I have only about $200/month (and still have to cover food, gas, cell phone bill etc).

So what I need your advice/opinions is on whether I should cash in my 401(K) to pay this debt off, or at least part of it. I've thought to cash in about $6500, and whatever debt I have left pay off with my income tax return. Yes, I have made horrible mistakes, but I'm trying to do better. I'm just so tired of paying and not even making a dent in my debt. I'm also getting married in September of next year. My fiance is very aware of my financial situation, so we've opted for just a simple ceremony (no reception etc), asked friends to help decorate, and use a personal friend as photographer to cut costs.

Your advice and opinion is much appreciated.

Thank you.

LRZ

[dczech09]

It is good that you are looking at improving your financial position and your fiancé is on board too!

I would NOT take money out of a 401k to pay off debt, unless it were to avoid bankruptcy. It does not sound like you are in that situation, so I would avoid drawing on the 401k. However, since your debt is at such high interest, it would be advisable to elect for 0% contributions on your 401k until the debt it cleared.

Attack the pay day loan first and get them out of your life! If you can sell something to do so, do it. Then focus on the credit cards once the pay day loan is out of the picture.

It sounds like your life insurance policy is a permanent (cash value) life insurance policy. Search this stuff on the forum and you will find A LOT of information on these types of policies. They are sold as investments and "retirement plans" even though it is illegal for agents to sell them that way. They are not a scam, however there is a better option for 99% of people. Being 34, and assuming you are in good health, I would do the following:

Step 1: Search the forum and read up on cash value life insurance, variable life insurance, whole life insurance, permanent life insurance, etc. You will come across one conclusion- term life insurance is the way to go. Also do some research online. It is important that you understand the difference between term life insurance and permanent life insurance. Even so, most people on the forum will agree with me- term is a much better deal in the end!

Step 2: Shop for a TERM life insurance policy with a face value of about 10X your income. So if you make $50k, look into a $500k policy. At your age, you could probably go for a 30 year term (15 or 20 if you do not plan on having kids). You should easily be able to find a policy for less than $200 per month. I just ran a quick quote online and found rates in the $40 per month neighborhood for a healthy person (non-smoker)!

Step 3: Once the term life policy is in force, cancel the Northwestern Mutual crap policy. Your agent will try to convince you stay, but do not listen. The only people who really like these cash value policies are the people who sell them. Trust me- a term life policy will be much better and will be MUCH cheaper. Do not let the agent fool you into thinking that the cash value policy is a retirement plan. It is not a retirement plan and the agent should lose their license if they push it as one. All you need is a basic term life policy.

By taking on a term life insurance policy and cancelling that expensive Northwestern policy, you will free up quite a bit of cash flow.

Clean up the debt, then knock retirement out of the park! Once you do not have that debt wrapped around your neck and you are not weighed down by an unnecessarily expensive life insurance policy, you will be able to save for retirement much easier.

Feel free to chime back with any questions!

[Petunia 100]

You should definitely not cash in your retirement money. That won't solve anything.

Instead, work on a realistic written budget. Identify the "fat" in your budget, and redirect that money towards debt. I can identify some fat right now: that expensive life insurance policy. Get some term insurance instead. Investments wrapped inside insurance policies are about the worst way to invest, the commissions and fees are astronomical.

Congratulations on your upcoming marriage.

[bjl584]

Using retirement savings to pay off debt is a bad idea 99% of the time. There are tons of reasons why this is so, but you would be much better served in the long run by working to pay off your debt without using your 401K. Pick up a second job, sell unwanted items, cut expenses, or a combination of all of these things.

[riverwed070707]

Agree with the others. I support a family of 3 on a similar income and we have money left over to save every month. What you need is a spending plan. Spend some time tracking your expenses and then create a spending plan. Come back here and post it and see if we can't find some places to help you trim down your budget and create a debt repayment plan. Chances are you can knock out that debt in a year or two while continuing to contribute to your retirement.

[disneysteve]

So in the last 2 years or so, I've managed to put up about $10,400 in a simple IRA.

I have credit card debt of about $4500 ... store card debt of about $2200... payday loan of about $1000

Your total debt is $7,700. In two years, you've saved over $10,000 in your IRA. Rather than cashing out what is already in there, just stop contributing for a year or so and use the money to pay off your debt.

Cashing out won't really help anyway. Do you realize that you will pay 35% or more on the money you cash out (10% penalty plus taxes)? That's considerably more than you are paying on the two credit cards (though likely less than on the payday loan). It doesn't makes sense to take out money at an even higher interest rate to pay off lower rate debt.

And I totally agree with getting rid of the whole life policy and replacing it with term. That will free up probably $150/month that can go toward the debt repayment.

[BuckyBadger]

I agree with the consensus.

1) Ditch the whole life policy. It doesn't matter how much you have already dumped into it. Stop digging the hole.

2) Focus on paying down that debt with those terrible interest rates, then done get yourself into any more. If you can put away $10k in two years you can pay off $8k in less than that time. In your case, since the rates really are pretty bad, I would decrease your contributions to max out your employer match, but don't contribute any more. Use everything else to pay down debt ASAP. Then continue on your very nice retirement contribution path.

Good luck.

[LRZ]

Thank you all very much for your input. I forgot to mention that I also had $0 emergency fund until about a year ago. Since then, I've been setting aside about $300 of my check every month to an account that's not as easily accessible to me as my savings account (which was always $0). I had to use little over $1000 for car repairs over the summer, but despite that, have saved up a little over $2000 now. Should I continue this, or hold off on adding more to it and pay off debt first, and then continue saving? I've read a few posts that advise to continue building an emergency fund despite debt, but just wondered if I should do the opposite?

dczech09: I've been reading a lot more on the whole life insurance plan, and you're right, seems like majority rule against it. I was talked into it by a friend which at the time seemed like a sweet deal (like it was guaranteed retirement money to supplement what ever I have in a 401(k) plan). I spent most of last night going through the paperwork I signed, and had a lot of "ah ha" moments! I probably haven't gotten to it yet on my papers, but how are agents/companies able to sell such insurance policies, claiming they can get us "money back?" Still haven't quite figured that out. And there's a lot of talk about dividends. Any insight on that?

Petunia 100: like the "fat" in my budget analogy. As all have agreed, once I cancel the whole life, that extra fat money will definitely go towards clearing my debt.

bjl584: great idea. I actually did sell my motorcycle this summer to pay off some debts. I sure miss the thrill of riding, but I think I love the feeling of having cleared some debt better. You made me think of some other little things I could get rid of, so guess I'll be back on craigslist.

riverwed070707: your response hit home cuz with a wedding coming up, being able to support a family is very high on my priority list. It also reminded me of my past marriage where I was making less, yet was able to support a family of 4. I've obviously lived beyond my means, and I want to get back in control of things. I started to jot down all my expenses, and will analyze where else to cut when all done. Thank you.

disneysteve: in the back of my mind I'm thinking yeah, I'll cash in a little to pay off part of the debt. Until your "It doesn't makes sense to take out money at an even higher interest rate to pay off lower rate debt." Completely missed to realize the interest I would be paying to cash in on the 401(k). The Payday loan...well, I plan on paying that off selling my kidney in the black market!!! In all seriousness though, that was a dumb move, but a lesson learned. I've already paid down $400 of it, and plan on throwing in all extra money to pay that off first.

BuckyBadger: by max out your employer match, do you mean I should drop my contribution to 3%, since that is what my employer matches? Obviously once debt is paid go back up to my 9%?

[dczech09]

dczech09: I've been reading a lot more on the whole life insurance plan, and you're right, seems like majority rule against it. I was talked into it by a friend which at the time seemed like a sweet deal (like it was guaranteed retirement money to supplement what ever I have in a 401(k) plan). I spent most of last night going through the paperwork I signed, and had a lot of "ah ha" moments! I probably haven't gotten to it yet on my papers, but how are agents/companies able to sell such insurance policies, claiming they can get us "money back?" Still haven't quite figured that out. And there's a lot of talk about dividends. Any insight on that?

Agents and insurance companies still sell these policies as if they were investments, even though it is illegal. The reason why they do it is either the agent is unaware of the illegality, or they can get away with it. It is hard to prove that an agent sold a policy this way (without voice recording them), so in a lot of cases, it goes undetected.

Insurance companies want these policies sold and will let the agents do virtually whatever they have to do to sell them. In fact, commissions on these types of policies are usually 50% to 100% larger than the commissions paid on term life insurance.

The "getting money back" part is probably due to either return of premium or the ability to keep your cash value. Either way, these are benefits that you have to pay extra for. So it is all a gimmick: they convince people that they are "giving" them money, when in reality the insurance company is only returning their money that they paid a long time ago. It is just like the government giving you your tax dollars back and acting like they did you a favor

Dividends are paid on these policies as a "return on investment" for the cash value. This is still a gimmick because this is not even an investment. Here is the scoop: as an owner of a life insurance policy, you are part owner in the company. Your dividend is the portion of the company earnings that flow to you as an owner. Instead of giving your cash though, they just credit the cash value on your policy.

I could go into excruciating detail on these policies and have actually been asked to create a workshop designed to cover all aspects on these policies (I am a person finance speaker on the side). To me- life insurance is easily the most complex topic in all of personal finance if only due to these types of policies being misrepresented so badly.

[disneysteve]

I forgot to mention that I also had $0 emergency fund until about a year ago. Since then, I've been setting aside about $300 of my check every month to an account
have saved up a little over $2000 now.

I would take $1,000 from that account and pay off the payday loan TODAY! Keep your kidney though.

how are agents/companies able to sell such insurance policies, claiming they can get us "money back?"

Of course they get you "money back". It's YOUR money that you paid in. But they took a huge commission so what you get back will never, ever exceed what you paid in. You will always lose money on these policies.

BuckyBadger: by max out your employer match, do you mean I should drop my contribution to 3%, since that is what my employer matches?

Yes, put in enough to get the full company match. That is an automatic 50% return on your money so it doesn't make sense to pass that up, even if it means keeping 26% debt a little longer.

[BuckyBadger]

Yes, put in enough to get the full company match. That is an automatic 50% return on your money so it doesn't make sense to pass that up, even if it means keeping 26% debt a little longer.

Yup - this is what I meant.

[llckll]

I agree with everyone else. Don't use your retirement account as you'll be susceptible to a 45% tax hit! Instead, stop contributing and pay down your debt using the avalanche method (highest interest rate first).

There is this free debt reduction spreadsheet that I'm using and it says that I can be debt-free in 9 years including my mortgage.

Do a search for vertex 42 debt reduction calendar.

Hope this helps...

Charlie
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