Paying Off Debt with Retirement Funds - The Finance Forums: Financial planning, debt help, loans, mortgages, retirement and 401k, investment, and general finance discussion forums

Rickytan · #1 (**permalink**) 01-15-2008, 05:16 PM

Looking for advice on a current situation.

I currently have approximately $115,000.00 in total debt which consists primarily of school loans. My wife and I currently have about $170,000 in our retirement funds, i.e. IRA, 401(K), etc... We have one credit card that we use, but I pay it off every month. I wouldn't say that I am struggling to make ends meet, but I am definitely not saving a whole lot each month. My wife continues to work on a part-time basis and I have my own practice. She continues to contribute to her 401(K), but I do not because there is just not enough for me to do so by the end of the month.

When I look at our monthly bills each month, I see that the big ticket items are the direct debits toward our loan payments, which alone, total about $1,400.00/month. That's basically an additional mortgage payment. The worst thing about it is that 99% of it is strictly toward interest!!! I'm sure you can see where I am going with this.

I have devised a plan whereby I would withdraw from our retirement funds over the next 3 years the total amount necessary to pay off all of our debt. In year 1, I would pay off the 2 smaller loans. I would then take the money that I would otherwise pay on those loans each month and apply it to the remaining "big" loan. In year 2, I would split the remaining balance of the big loan in half and withdraw the additional amount necessary to pay 1/2 of the remaining big loan. I would then take the money that I would be otherwise paying and apply it to the remaining balance. In year 3, I would withdraw whatever funds were necessary to payoff the big loan and would therefore be debt free with the exception of the house costs, i.e. mortgage, utilities, taxes, etc...

The next level of my plan would then be to start saving aggressively since I have now opened up approximately $1,400.00 month. Each month I would dump the $1,400.00 that I used to pay toward interest on my loans into my SEP. Every year, the amount I would deposit would increase in proportion to the increase in profits that my practice makes (of course this is assuming that my practice continues to grow at its current pace). The money that I contribute to my SEP is a write-off as I understand, so that would be a plus.

The whole point of the above is this: I am sick and tired of paying $1,400/month toward interest. I can afford it, but I just never feel good about it. While I pay $1,400/month toward interest in real time, I am making about 9% on money that I cannot touch until I am 60. I just feel like the fruits of my labor and all the hard work should go toward something rewarding. It would make a huge difference to me to contribute money toward my retirement than toward interest. Again, I am not currently contributing to my SEP or other IRA and my wife at this time contributes $560/month into her 401(k) (this includes her employer match). If I could free up that money, together we would put away almost $2,000/month as a start toward retirement. FYI, we are both 35 years old and have 3 kids. At $2,000/month for the next 30 years, we would save $720,000 in cash alone. I would assume that interest would contribute a great deal to that amount of money.

I am well versed about the penalties and the taxes that I would incur. However, assuming we can withstand those negatives, is this plan worth a try?

Sorry for the long message, but I wanted to make sure I laid out the entire scenario.

vanman2099 · #2 (**permalink**) 01-15-2008, 06:55 PM

So you're losing nearly all 1400 a month to interest or about $16,800 annually.

If your retirement fund grows around the average market rate and kicks off a 10% return each year, you're gaining about $17,000 annually on your retirement plan if it matches the market return and these are some pretty bad times for the US market right now, which it may not be putting out a good return.

You can see just from those numbers, you are not gaining ground by much every year. You give 16,800 away still have 115k debt, and if you were to subtract that money from your return on your retirement plan you would end up about break even (actually losing after inflation) each year. If you aren't contributing more to retirement then you're really stalemated.

Your plan sounds solid and it sounds like you've thought it through. You're going to pay it out over 3 years which is good also so you don't burn 115k right out of your retirement fund. Are there any programs you can hop onto that allow you to pay off debt with your retirement plan?

Do you own a house and have you considered taking out a home equity loan to pay off your school loans and then using your retirement plan to pay off your home equity loan? I believe you are allowed to use your retirement plan in some manner toward your primary residence without penalty.

What I used to do when I worked is put 2% into my 401k because my employer would match 2% (even though I didn't have 2% to give I would just suffer through the year and do it) then at end of year I would take all of my money back out and take the penalties because it didn't really matter, I would pay 10% I think it was at the time in penalties to receive 100% match for my retirement, ie, say I put in 1000 a year, my employer matched that so they'd put in 1000, I'd take my 1000 out at end of year, pay 100 dollars in penalties and still have 1000 dollars in my retirement account from the company. For every 100 dollars I paid in penalties they gave me 1000 dollars toward retirement, what a deal hey? BTW, I was in one of those low tax brackets that I always got money back at end of year.

What I would do next is calculate the potential loss from not having the money in your retirement fund over the next 3 years (use 10% or your average return) then I would add that to your penalties suffered for additional taxes or capital gains taxes and come to a total amount, plus anything else you can think of. Then calculate at what point you will make up for it by not having any debt, and adding an additional 1400 each month to your retirement. There should be a break even point you can calculate so many years down the road where you will then start go go ahead. If that number works for you and you feel comfortable with it, then I would do it, like yesterday.

Hermes · #3 (**permalink**) 01-17-2008, 09:40 AM

I agree with vanman,

if you are comfortable with it...go for it. You are young and if you will be able to be debt free in three years you may want to go ahead and proceed.

It is not necessarily what I would do but that doesn't matter at all. The only thing that I do not like about your plan is that you use your assets to pay off liabilites.

Once again if you like the plan and are happy with it then execute it.

GarySpicuzza · #4 (**permalink**) 01-17-2008, 02:22 PM

Rickytan your plan is flawed on several levels.

#1) Withdrawals from your IRA and 401K plans prior to age 591/2 will carry with them a 10% penalty from the IRS PLUS you will pay ordinary income tax on the funds you withdraw. In a 28% tax bracket it will cost you 38 cents for each $1.00 dollar you withdraw leaving you with 62 cents on the dollar.

#2) In most all states, and I will be the first to admit I know nothing about Illinois, retirement funds, IRAs, 401Ks and Annuities ARE EXEMPT FROM LEGAL PROCESS. So even if you filed for bankruptcy the money in those funds would be EXEMPT from creditor claims.

#3) Further, in most ALL states and especially in Florida (I know nothing about Illinois) your Homestead is exempt from creditor claims. See O.J. Simpson regarding both #1 and #2 above!

So what to do?

a) Leave the $170,000 dollars alone. It should just double about every 10 years so at age 65 without contributing another penny you should have about $680,000.

b) Don't take out a second mortgage on your home to pay off unsecured debt. That does nothing but turn an EXEMPT asset into a money pit.

c) STOP borrowing money.

d) Figure out ways to earn more money and reduce expenses until your debt is paid.

e) I would have the wife stop contributing to her 401K and put that money towards your debt until it’s paid. The interest on your debt probably exceeds what you are earning on the 401K (excluding employer contribution) so in a reverse way you are earning the spread by NOT paying interest proportionally to the principal you are paying down.

Edit: I wrote above:

Quote:

a) Leave the $170,000 dollars alone. It should just double about every 10 years so at age 65 without contributing another penny you should have about $680,000.

The correct number would be $1,360,000 at age 65 without contributing another penny!

Age 35 $170,000

Age 45 $340,000

Age 55 $680,000

Age 65 $1,360,000

That should open your eyes as to why you DO NOT and should not destroy the savings you already have to pay off UNSECURED debt.

GarySpicuzza · #5 (**permalink**) 01-20-2008, 01:25 PM

Shamelessly bumping this thread to the top of the message board because I like my answer and in doing so this shameless bump gives me a feeling of some sort of Internet power where none actually exists!

cbass1017 · #6 (**permalink**) 01-21-2008, 06:19 AM

I would have to agree that you should take out some of your retirement, but by all means not all. something you have to keep in mind with your 401K though is that you may not always make 10%. Some employers only give you certain options for your retirement funds and with the way the market has been going lately 10 % seems a bit far fetched. Don't get me wrong though, I'm far from an investor. I only handle retail banking products where I work now. I would say that if you can manage to pay off your debt in 3 years and then make the commitment to putting that interest you used to be paying directly towards your retirement to make up for the lost time you will be in good shape come retirement.

GarySpicuzza · #7 (**permalink**) 01-21-2008, 12:05 PM

cbass1017 wrote:

Quote:

I would have to agree that you should take out some of your retirement,...

cbass1017, for the sake of argument, on what mathematical theory does that work?

If Rickytan takes money out of their 401k it will cost him 38% for each dollar withdrawn PLUS he will no longer earn money on the amount he withdraws and if he averages 7% per year on his 401k it will cost him 45 cents for each dollar he withdraws.

Now there is no way the interest rate he's paying is anywhere close to 45%.

He said the bulk of his debt, "consists primarily of school loans"
Those are low interest loans usually in the 6% to 8% range.

Anyway, it makes no sense to me to cost yourself 45 cents on the dollar to pay off UNSECURED debt.

Mynion · #8 (**permalink**) 01-21-2008, 05:35 PM

Gary is right on.

Most people do not understand the "time value of money". Without time, mathematically your rate of return is always 0%. Rate of Return only works when time is factored in.

For example, most people do not know this, but if you started saving $10k/year in a 401k at age 25, earning 7%, and continued to do so throughout retirement at age 65... The $10k that you put in at age 25 would grow to $150k. The $10k you put in at age 50 will only grow to $28k.

This is called the "efficiency of a dollar". The dollar you invest at any age is more efficient than any dollar invested that follows it, for any fixed period of time. This is irregardless of inflation.

These 401k dollars you already have invested are more efficient dollars than any new dollars you could invest. Therefore, regardless of the inherent tax problems associated with withdrawals, the fact is that any dollar you invest in the future will be less efficient.

Combine that with the tax implications, and you have a losing strategy any way you look at it.

cbass1017 · #9 (**permalink**) 01-22-2008, 04:25 AM

I appologize for the misunderstanding. I guess I believed that most employers will allow you to take a loan out on your 401k or retirement plan so you don't have to pay any tax penalties and the small amount of interest you pay back you are actually paying to yourself. I know my current and previous employers allowed that and I thought most do. I took a loan out on my 401K becaues a lot of stocks were taking a hit anyways. I paid off some high interest rate credit cards and am now paying back that money at an interest rate of 7% which goes right back into my 401K. Do you really think I was extremely stupid to do this because it seemed to make a lot of sense to me?

TripleS · #10 (**permalink**) 01-22-2008, 04:54 AM

But isn't it make the money in retirement fund become more and more lesser? This mean, we can't have enough money to allow us to retirement comfortably in out old ages...any other plans can be share?

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