Paying off debt with your 401(k)

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Dear Debt Adviser,
I am in debt with credit cards and unsecured loans. I have a house and two vehicle payments. In today’s economy, I can only afford to pay for our home and cars. Unsecured debt is around $80,000. Can I use my 401(k), at $184,000, to pay debt or pay my house off? Either one paid off would bail us out.

Dear GAC,
Whoa there, GAC! Before you burn through your retirement savings, I want you to take a few minutes and look at where you are and how you got into this situation. By jumping ahead directly to solutions, you might end up solving the symptom but never addressing the cause of your problem. This virtually guarantees that it will reoccur in the near future. You say you can’t afford to pay anything but your car and home payments. You can put it another way: You can’t afford your lifestyle. My suggestion is to fix today’s problems with today’s resources and look forward to a better life tomorrow. Emptying tomorrow of its resources could end up with you wandering in a financial wasteland in your senior years.

Enough doom and gloom. Let’s get this problem on the way to a solution! First on the list of things I want you to take a hard look at are how and why you have $80,000 in unsecured debt. I want you to plug the holes in your spending habits that have caused the massive leak that has created an ocean of debt. The debt piled up because you were living beyond your means. So I want you to make the commitment to begin living within your means as soon as possible.

To turn this commitment into reality, I suggest you begin with a spending plan or budget. Once you know where your money is going, you can make decisions about setting new spending priorities and allocating enough cash flow to retire your unsecured debt. I suggest that you set a goal to get this debt retired in five years or less. I want you to write down and add up all of your expenses for a month. Try to account for at least 90 percent of all your income. The final 5 percent to 10 percent will be small out-of-pocket purchases that you don’t even know you are making.

Next, make some decisions to cut unnecessary spending and then write that down too. Now you have a plan. To speed up the process, some things you might consider include getting a temporary second job or downsizing to only one car for awhile. If you need two cars — really, really “need” two cars — consider selling one car and buying another less glorious one with the net proceeds, without a loan. However, this tactic will only work if you can sell your car and pay off what you owe on the loan. If you owe more than what the car would bring at sale, then car downsizing won’t work.

I suggest a five-year repayment schedule. It is probably more important to set a goal date by which you will be debt free than to just say five years. But, that said, five years may be about right. Doing the math, to pay off an $80,000 balance at a 12.5 percent interest rate — your actual rate may be more or less — you would need to pay $1,800 a month to be debt free in five years.

If you don’t like my math or perhaps think that raiding your retirement future is easier, let me add this. If your age is under 59½, you will owe a penalty in addition to taxes on the money you withdraw. How much? My guesstimate is that increasing your income in one year by enough to net $80,000 will drive you to a much higher tax bracket. So when you figure in the penalty, you will need $116,500 to erase your $80,000 mistake. Still sound like a good deal?

Let’s have more fun with numbers. I estimate that the $116,500 you’d have to take out of your retirement account now would have been earning 6 percent for the next 20 years. That makes your trade even worse, by using more than $350,000 of future cash for an $80,000 problem today.

I hope I’ve persuaded you to leave your 401(k) alone. I think even Popeye’s friend Wimpy — “I’ll gladly pay you Tuesday for a hamburger today” — would agree!

Good luck!

Read more Debt Adviser columns and more stories about debt management.