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Pay Off Debts with your 401k?

Bad Financial Situation
Lets look at a common bad financial situation. You are over $20,000 in debt, and your monthly payments exceed your monthly income by a couple hundred dollars. You are thinking about using your 401K by taking a withdrawal but you are worried that you will lose a huge amount of money because of penalties and taxes. What should you do?

Assets & Debts - Not Uncommon
Americans spend 1% more than they make in a year. This accumulates debt. At the same time Americans have accumulated over $1 trillion in 401K plans. These are accumulated assets. This seems to be a contradiction and common sense would dictate that debts are paid first, but many Americans find the tax differals hard to resist especially if their employers are contributing to the fund as well. Does it make sense to tap into your 401K to pay off your debts and bills?

Typical Example
For this example lets assume that you are 30 years old, you will retire at 65, your tax bracket is 15% and that you are $21,000 in debt. To pay off your debt completely, you will need to withdraw $28,000 from your 401K to pay off the 10% withdrawal penalty as well as income tax on the money withdrawn from your 401K. You may be able to pay less penalties if you apply for a hardship withdrawal but unless you are paying off medical bills, your chances of the IRS granting you a hardship withdrawal are not over good.

What will it Really Cost?
Let's say you left that $28,000 in your 401K until you retired at age 65 and that the 401K plan earned 5% each year. It would then be worth $154,000. When you retired, you would then receive a check for $640 a month for the rest of your life. In simple terms, paying off your current debts and borrowing $28,000 from your 401K plan will cost you $154,000 in the long run. That's is a very expensive loan by any means.

Alternatives
Unless it is your only option, my advice to you is to find an alternative to tapping into your 401K. Consider re-financing your home, getting a home equity loan or get some help through debt consolidation or credit counseling. Cut down your cost of living expenses so that you can start paying off your debts interest and capital. No matter what you do, you will have to reduce your expenses or increase your income so that you stop accumulating debt every month.

Change your Lifestyle
If your lifestyle creates debt for you every month, you must change it. In short you cannot afford your lifestyle so you need to find one that you can afford. There are many ways you can cut your monthly expenses if you think about it and commit yourself to the idea of being debt free. Most people can fin some money in their grocery bill. You can sell your car and car-pool. You can move to a smaller home or apartment. You can get a second job or do more overtime at your current job. Get yourself in the black as soon as you can or you will end up in a downward spiral towards bankruptcy.

The Reality About Debt
The cold reality about debt is that you cannot be in a position where you accumulate debt every month. Everyone has extra expenses once in a while but if you are in a situation where you are accumulating more and more debt every month, you must get out of it. Even if you use your 401K to pay off your current debts, you will be in the same place and faced with the same situation a few more years down the road unless you change your lifestyle to match your income.

Article written by SAM
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