Sister in law is getting married. Her and her soon to be have about $90k in debt. Based on current and future income, it will take about 5 years to pay off. I've been helping with budget and planning. He has about $120k in a 401k. I've always held 401k sacred and never cashed out. Why should they not cash out and come close to paying off now?
Cashing out 401k?
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Last: 9 yr ago by JDCAG (NOT Colin)
Not a financial planner, but they will be hit by income tax plus a 10% early withdrawal penalty.
What is the nature of the debt? If they have $120K in their retirement accounts, sounds like their income is strong and they can just pay the debt down with cash flow.
What is the nature of the debt? If they have $120K in their retirement accounts, sounds like their income is strong and they can just pay the debt down with cash flow.
Mostly credit card. He maxed out 401k for a few years but hasn't touched it recently while in grad school. They also have about $140k in student loans.
Well I don't know that I would do it unless they just needed to. You are going to have to pay the 10% penalty, plus taxes... Which depending on their current income could be very high.
So I doubt the 120k even ends up covering the 90k
I would cash it out...buy a rent house...use that cash flow to pay off the student loan...so you keep most of your capital and use the newly added cash flow to move the bad debt off your books.
So I doubt the 120k even ends up covering the 90k
I would cash it out...buy a rent house...use that cash flow to pay off the student loan...so you keep most of your capital and use the newly added cash flow to move the bad debt off your books.
because exercising financial discipline, sticking to a budget and working to reduce debt are more important than not learning a lesson, raiding a retirement asset, and losing out on 5 year gains inside of a 401k.
when you do it once... you'll do it again in a financial dilemma
I've seen it over and over again... people that can't control budgets have little to no assets... of anything.
when you do it once... you'll do it again in a financial dilemma
I've seen it over and over again... people that can't control budgets have little to no assets... of anything.
quote:
Mostly credit card. He maxed out 401k for a few years but hasn't touched it recently while in grad school. They also have about $140k in student loans.
Yikes. Each one of those sentences is mind boggling. So their total debt load is really around $230K.
Still, they must have impressive income if they think they can pay down the $90K debt in 5 years. Assuming 15% interest on the credit card debt, that works out to a $2,150 monthly payment to pay off the debt in 5 years.
quote:
I would cash it out...buy a rent house...use that cash flow to pay off the student loan...so you keep most of your capital and use the newly added cash flow to move the bad debt off your books.
Strikes me as overly complicated for a couple who managed to find themselves owing $230K to lenders...
If they have cash flow to pay down the $90K in 5 years, then I'd leave the 401K untouched. I would tap it only as an absolute last resort if I didn't have cash to meet my day-to-day obligations.
I have a friend that pulled out roughly $38K out of one of his old 401k last year. I've always been interested to see the real math when this happens, so I asked a few questions.
The way he explained it was 10% penalty right off the top ($3800), so already down to ~$34K ($12K in bringing it down to $108K). Then the holder of the 401k sent 20% right to the IRS from the full $38K ($7600), so down to ~$26K ($24K bringing it down to $84K). The $26K was what he got a check for ($84K).
I asked him how he did on taxes a few weeks ago and he regretted the decision, as that $27K bumped his income for the year into the next tax bracket. So where he would have been flat or gotten a small refund in previous years, he owed quite a bit.
So it comes down to just how worth it is to him to pull a pretty decent start to 401k out to pay debt (and include some cash up front because it won't cover the full $90K). Then take the hit on income tax for the rest of his yearly income and have to write another check to the IRS.
The way he explained it was 10% penalty right off the top ($3800), so already down to ~$34K ($12K in bringing it down to $108K). Then the holder of the 401k sent 20% right to the IRS from the full $38K ($7600), so down to ~$26K ($24K bringing it down to $84K). The $26K was what he got a check for ($84K).
I asked him how he did on taxes a few weeks ago and he regretted the decision, as that $27K bumped his income for the year into the next tax bracket. So where he would have been flat or gotten a small refund in previous years, he owed quite a bit.
So it comes down to just how worth it is to him to pull a pretty decent start to 401k out to pay debt (and include some cash up front because it won't cover the full $90K). Then take the hit on income tax for the rest of his yearly income and have to write another check to the IRS.
It is a mess. They didn't do all this together. He brought about half the student loans and about $15k in credit card, she brought the rest. Sister in law was the problem. Did school, grad school to stay in school longer and now has a job at $45k/year with little upside. After school, we had her move in with us to get free rent and a little "education". I am, by no means an expert or perfect, but her and her sister had no financial sense given to them by their parents. I saw my parents go through bankruptcy in high school and that will make you become a Dave Ramsey fan real quick.
Thanks for the advice. This is what I thought, but I wasn't sure about penalties. I looked on mine, but didn't see the 10% penalty.
Thanks for the advice. This is what I thought, but I wasn't sure about penalties. I looked on mine, but didn't see the 10% penalty.
quote:
I asked him how he did on taxes a few weeks ago and he regretted the decision, as -that $27K bumped his income for the year into the next tax bracket. So where he would have been flat or gotten a small refund in previous years, he owed quite a bit.
So it comes down to just how worth it is to him to pull a pretty decent start to 401k out to pay debt (and include some cash up front because it won't cover the full $90K). Then take the hit on income tax for the rest of his yearly income and have to write another check to the IRS.
That's not how income tax brackets work.
quote:
Well I don't know that I would do it unless they just needed to. You are going to have to pay the 10% penalty, plus taxes... Which depending on their current income could be very high.
So I doubt the 120k even ends up covering the 90k
I would cash it out...buy a rent house...use that cash flow to pay off the student loan...so you keep most of your capital and use the newly added cash flow to move the bad debt off your books.
Still trying to make sense of taking a 30% hit on a tax deferred asset to do this.
quote:
because exercising financial discipline, sticking to a budget and working to reduce debt are more important than not learning a lesson, raiding a retirement asset, and losing out on 5 year gains inside of a 401k.
when you do it once... you'll do it again in a financial dilemma
I've seen it over and over again... people that can't control budgets have little to no assets... of anything.
This.
What about taking a loan against the 401k to pay off 50k of the debt. Then work on paying back everything. Likely save a lot on interest that way
Maybe I'm confused or he was...isn't it treated like income and thereby adjusting your AGI? He might have had other tax situations that made him pay rather than receive a refund that I didn't ask about.
Maybe it was the additional 5% needed to satisfy the tax on just the $38K, that caused him to owe money (single filer). In the OP's case, the guy would be short another 5% in taxes on $120K (as a married/jointly filer) if it's separate like I think you are alluding to.
Maybe it was the additional 5% needed to satisfy the tax on just the $38K, that caused him to owe money (single filer). In the OP's case, the guy would be short another 5% in taxes on $120K (as a married/jointly filer) if it's separate like I think you are alluding to.
I agree it may not make sense in all cases but in this case if they feel they need to pay it off then rather than just lose the capital by paying all the debt off at once, they use cash flow to pay the debt down from a rental property then they keep their capital in tact.
The money being trapped in a 401k won't help the fact that they need to pay the debt each month. Pulling it out and getting cash flow with it allows them to keep most of their capital... But pay down the debt at the same time.
The money being trapped in a 401k won't help the fact that they need to pay the debt each month. Pulling it out and getting cash flow with it allows them to keep most of their capital... But pay down the debt at the same time.
quote:Ignoring the student loans for a moment, the question is should they cash out federally bankruptcy protected accounts to pay unsecured consumer debt while taking a massive tax hit to do so?
Why should they not cash out and come close to paying off now?
I'm going to have to say no.
Yes. But it doesn't move all of your money into a new bracket.....just the money above that bracket line.
There are lots of factors that can move AGI, but assuming everything was static, taking the money out as income for this year doesn't move all of his money into a different bracket.
I didn't realize there was a big misconception on this until a few years ago and a business owner that had used accountants his whole life, and had been all over the map on incomes, was carrying on about how if he made a few thousand extra this year all of his money was going to "get hit by the next bracket". After he figured out that's not how it works, I started asking other professionals/business owners that question quite often during our discussions, and I'd say around half of all people I have that chat with believe that's how it works.
There are lots of factors that can move AGI, but assuming everything was static, taking the money out as income for this year doesn't move all of his money into a different bracket.
I didn't realize there was a big misconception on this until a few years ago and a business owner that had used accountants his whole life, and had been all over the map on incomes, was carrying on about how if he made a few thousand extra this year all of his money was going to "get hit by the next bracket". After he figured out that's not how it works, I started asking other professionals/business owners that question quite often during our discussions, and I'd say around half of all people I have that chat with believe that's how it works.
quote:
Maybe I'm confused or he was...isn't it treated like income and thereby adjusting your AGI? He might have had other tax situations that made him pay rather than receive a refund that I didn't ask about.
Maybe it was the additional 5% needed to satisfy the tax on just the $38K, that caused him to owe money (single filer). In the OP's case, the guy would be short another 5% in taxes on $120K (as a married/jointly filer) if it's separate like I think you are alluding to.
If he owed money it was because he miscalculated what he should have taken out.
If you're going to get a $2,000 on a $90K salary and you do a 401K withdraw, it doesn't change the math on your taxes with regard to the $90K. If you, however, don't take out the appropriate amount, given your other forms of income (in the case of my example, your $90K) and your deductions, etc. then you may end up taking out far too little on the $38K, in which case it will come due at tax time.
But again, that has everything to do with withholding too little and nothing to do with it impacting his normal refund. It's just the fact that somebody taking cashing out $20K while making $35K will be taxed against it differently than somebody taking out $20K while making $150K.
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quote:
Sister in law is getting married. Her and her soon to be have about $90k in debt. Based on current and future income, it will take about 5 years to pay off. I've been helping with budget and planning. He has about $120k in a 401k. I've always held 401k sacred and never cashed out. Why should they not cash out and come close to paying off now?
Any argument for doing this would revolve around the "emotional" side of the equation.
Money wise, it flat doesn't make sense and it's not difficult to see/explain why.
These people think they can pay off the debt within 5 years. At that point, you're basically comparing which of the following comes out to more money -
the money lost due to the 10% penalty, the money lost due to income taxes and the money lost due to the money being out of the market
vs
the interest lost over the next 5 years of paying off their debt (which should be a decreasing amount as time moves along and the debt becomes smaller)
They would have to have one hell of a horrible rate to make the math say that they're better off taking the hit....
Now, if there was an emergency, or something major happened in their lives and that 401K withdraw meant the difference between losing a house, or going into collections or something, it would potentially change the math.
But if everything will be paid off eventually (especially in a 5 year time horizon) and nothing else is going to happen as a result of taking that time (beside a level of interest accrual that will also be paid off by the 5 year time line) then it just isn't worth it.
As everyone has said it just depends on the Math. For instance..lets assume the 90k is all credit card at 16% and the two different strategies below:
Keep 401k:
So they are going to pay it off in 5 years with interest that means they will pay $2188.63 every month for a total of $131,317 .8 over the 5 years.
If they leave in the 120k assuming gains of 5% each year (Which i think in the current environment would be amazing)...they will end up with $153,153.79 in the 401k over the same period.
Withdrawal of 401k
If instead they cash out the 120k and end up with say 90k. Then say they took the monthly payment of $2188.63 and put that in the bank for 5 years they would end up with $131,317.8. So technically keeping it in the 401k wins but remember that $131,317.8 is tax free and penalty free. Also remember this option is fairly risk free....meaning you don't have to worry about a market crash.
I would make sure they try to get a consolidation loan either way...especially on the credit card debt. One reason is interest rates are at historic lows....locking in a lower rate would be great and it insures that if the Fed raises the rate (I know I know never going to happen...but it could) then they are not getting killed with more interest.
In the end though these numbers change drastically based on the debt interest rate and the assumption that the 401k doesn't loose money. The above is just an example that when you do the Math you may find that you prefer taking the hit even with prepayment penalty and tax to end up with for sure the debt paid off and $131,317 tax free liquid cash.
Keep 401k:
So they are going to pay it off in 5 years with interest that means they will pay $2188.63 every month for a total of $131,317 .8 over the 5 years.
If they leave in the 120k assuming gains of 5% each year (Which i think in the current environment would be amazing)...they will end up with $153,153.79 in the 401k over the same period.
Withdrawal of 401k
If instead they cash out the 120k and end up with say 90k. Then say they took the monthly payment of $2188.63 and put that in the bank for 5 years they would end up with $131,317.8. So technically keeping it in the 401k wins but remember that $131,317.8 is tax free and penalty free. Also remember this option is fairly risk free....meaning you don't have to worry about a market crash.
I would make sure they try to get a consolidation loan either way...especially on the credit card debt. One reason is interest rates are at historic lows....locking in a lower rate would be great and it insures that if the Fed raises the rate (I know I know never going to happen...but it could) then they are not getting killed with more interest.
In the end though these numbers change drastically based on the debt interest rate and the assumption that the 401k doesn't loose money. The above is just an example that when you do the Math you may find that you prefer taking the hit even with prepayment penalty and tax to end up with for sure the debt paid off and $131,317 tax free liquid cash.
Hard truth:
They're a couple that's managed 230k of debt (including 90k of consumer debt) and they're not even married yet. It's not like they had kids in day care, no mention of any medical debt that would have contributed to this situation, no mitigating factors that I've seen in this thread for amassing such a debt burden. Just student loans and CC debt, yes?
90k in consumer debt is simply profligate. The student loans are questionable depending on degree and earning capability.
They need to establish some financial discipline and build a life together where they are both working towards financial goals responsibly. One spouse could easily wreck this for the other.
Please consider the real possibility that they (or one of them) could dig this hole deeper after marriage and eventually need to file for bankruptcy. You didn't list assets, but I'm guessing they're insolvent at this point. Keep what little assets they have as protected from creditors as possible. That means 401ks and IRAs (state dependent) stay untouched.
They're a couple that's managed 230k of debt (including 90k of consumer debt) and they're not even married yet. It's not like they had kids in day care, no mention of any medical debt that would have contributed to this situation, no mitigating factors that I've seen in this thread for amassing such a debt burden. Just student loans and CC debt, yes?
90k in consumer debt is simply profligate. The student loans are questionable depending on degree and earning capability.
They need to establish some financial discipline and build a life together where they are both working towards financial goals responsibly. One spouse could easily wreck this for the other.
Please consider the real possibility that they (or one of them) could dig this hole deeper after marriage and eventually need to file for bankruptcy. You didn't list assets, but I'm guessing they're insolvent at this point. Keep what little assets they have as protected from creditors as possible. That means 401ks and IRAs (state dependent) stay untouched.
What about a 401k loan instead of a withdrawal? At least that way it isn't taxed, and you are paying your retirement account the interest.
quote:I'm not super knowledgable about them, and I'd have some concerns, mostly about what happens in case of job loss (loan repayment typically) and and the loss of investment returns (assuming market goes up). Beyond that I would probably consult someone more knowledgeable in these matters, especially considering these assets were acquired pre-marriage but would be getting repaid with after-marriage money. Co-mingling money is an easy way to get minus 50% return on your money someday.
What about a 401k loan instead of a withdrawal? At least that way it isn't taxed, and you are paying your retirement account the interest.
I've never been called a love-struck optimist, that's for sure
quote:risk on assets isn't an issue here because you can be conservative in the 401k or risky with the new savings amount at the bank
As everyone has said it just depends on the Math. For instance..lets assume the 90k is all credit card at 16% and the two different strategies below:
Keep 401k:
So they are going to pay it off in 5 years with interest that means they will pay $2188.63 every month for a total of $131,317 .8 over the 5 years.
If they leave in the 120k assuming gains of 5% each year (Which i think in the current environment would be amazing)...they will end up with $153,153.79 in the 401k over the same period.
Withdrawal of 401k
If instead they cash out the 120k and end up with say 90k. Then say they took the monthly payment of $2188.63 and put that in the bank for 5 years they would end up with $131,317.8. So technically keeping it in the 401k wins but remember that $131,317.8 is tax free and penalty free. Also remember this option is fairly risk free....meaning you don't have to worry about a market crash.
I would make sure they try to get a consolidation loan either way...especially on the credit card debt. One reason is interest rates are at historic lows....locking in a lower rate would be great and it insures that if the Fed raises the rate (I know I know never going to happen...but it could) then they are not getting killed with more interest.
In the end though these numbers change drastically based on the debt interest rate and the assumption that the 401k doesn't loose money. The above is just an example that when you do the Math you may find that you prefer taking the hit even with prepayment penalty and tax to end up with for sure the debt paid off and $131,317 tax free liquid cash.
in the above bold, I would bet the 25% is way too low - the tax and penalty together would be at least 35% (leaving 78k). The amount of tax depends on how much they make, then add in the 120k.
quote:Only way this could work is rolling over (if can) or take an in-service distribution to a self-directed IRA and buy the rental in the IRA.
Well I don't know that I would do it unless they just needed to. You are going to have to pay the 10% penalty, plus taxes... Which depending on their current income could be very high.
So I doubt the 120k even ends up covering the 90k
I would cash it out...buy a rent house...use that cash flow to pay off the student loan...so you keep most of your capital and use the newly added cash flow to move the bad debt off your books.
Dumbest financial decision I ever made was taking out a cheap home equity loan to pay off credit cards. This would even be worse.
quote:I'm actually not sure how the penalty works and then what is available to be taxed. For instance is it you take 10% penalty first then you only have 108k available to be taxed...which leaves you at 81k if you assume 25%. I don't know at all so I would have to talk to someone far more qualified than I.quote:risk on assets isn't an issue here because you can be conservative in the 401k or risky with the new savings amount at the bank
Withdrawal of 401k
If instead they cash out the 120k and end up with say 90k. Then say they took the monthly payment of $2188.63 and put that in the bank for 5 years they would end up with $131,317.8. So technically keeping it in the 401k wins but remember that $131,317.8 is tax free and penalty free. Also remember this option is fairly risk free....meaning you don't have to worry about a market crash.
in the above bold, I would bet the 25% is way too low - the tax and penalty together would be at least 35% (leaving 78k). The amount of tax depends on how much they make, then add in the 120k.
But all that is dependent once again on how much they make. I agree that you are probably looking at more like 78k vs 90k. But I don't know the actual numbers. My point was that to me there can be a case for doing the withdrawal. To me if you offered me 120k free and clear vs "the chance" to have 150k in a 401k I would take the 120k all day. Just my personal preference as I don't like the 401k as a retirement vehicle and prefer real estate. But to each his own.
quote:Well this is once again a math game. It "can" work but it depends on if you think the Rental house can far out pace the return of the 401k minus the initial loss of the taxes and penalties.quote:Only way this could work is rolling over (if can) or take an in-service distribution to a self-directed IRA and buy the rental in the IRA.
Well I don't know that I would do it unless they just needed to. You are going to have to pay the 10% penalty, plus taxes... Which depending on their current income could be very high.
So I doubt the 120k even ends up covering the 90k
I would cash it out...buy a rent house...use that cash flow to pay off the student loan...so you keep most of your capital and use the newly added cash flow to move the bad debt off your books.
Full disclosure, I did this very thing. I cashed out some old 401k...took the penalties....payed the taxes and bought several rental houses. Absolutely the best decision I have made. I did this when the housing market was very depressed. As such I was able to get the homes for vastly under even their rebuild cost. Since then the home values have sky rocketed and rents are becoming ridiculously high. So I have a great monthly cash flow and my unrealized capital gains far outpaced what I would have gotten in the market during the same period. The math made sense. It won't always, but I know some people view the 401k as some sacred cow. You can't touch it....it is the only way to retire...you need to max it out.
I mean to me the OP's thread is a great example. This person he knows is racking up credit card debt close to 90k at 16% but maxing out his 401k at the same time which earns maybe 7% on average. That is crazy.
quote:I'm curious, if you don't mind me asking, why you didn't like this coarse of action. I mean it would seem that trading a high interest non tax deductible loan for a lower interest, possibly tax deductible, loan would be better.
Dumbest financial decision I ever made was taking out a cheap home equity loan to pay off credit cards. This would even be worse.
First I took unsecured cc debt and made it secured against my home. A bad and unnecessary risk, had one of us lost our jobs shortly thereafter or even if I had been transferred and forced to sell, it could have ended badly. Second, it doesn't solve the underlying problem of cc spending. You have to solve that first. Luckily we learn, the second time our debt got to high, we paid off College loans, cc debt and had two kids in Jr High. And have tried extremely hard to be cash only since. If you have the discipline and lifestyle adjustments to solve the problem, you can pay it off normally and maybe that added expense will be a motivator going forward.
you are taxed on the total amount - so 120k, not the 108k net after the penalty.
As for rentals with the 401k money - that is okay to do if the person wants to work at it.
My advice is to consider rolling/transferring into an IRA and have the IRA buy the real estate. That way, you aren't dealing with the tax issue.
You probably didn't have that option when you did it, but it is something to consider if you are dead set on being in real estate.
Curious when you sold out of the 401k for the real estate. Real estate was cheap in 2009, but so was the stock market. The stock market has nearly tripled from the bottom in 2009.
Both real estate and stocks are great for everyone to own both at the same time.
As for rentals with the 401k money - that is okay to do if the person wants to work at it.
My advice is to consider rolling/transferring into an IRA and have the IRA buy the real estate. That way, you aren't dealing with the tax issue.
You probably didn't have that option when you did it, but it is something to consider if you are dead set on being in real estate.
Curious when you sold out of the 401k for the real estate. Real estate was cheap in 2009, but so was the stock market. The stock market has nearly tripled from the bottom in 2009.
Both real estate and stocks are great for everyone to own both at the same time.
quote:I agree, but I think he/she is saying that until you correct the spending problem, you are destroying yourself. Pull from your house to payoff cards and then run up the cards again may mean that you now lose your house (if continued).quote:I'm curious, if you don't mind me asking, why you didn't like this coarse of action. I mean it would seem that trading a high interest non tax deductible loan for a lower interest, possibly tax deductible, loan would be better.
Dumbest financial decision I ever made was taking out a cheap home equity loan to pay off credit cards. This would even be worse.
If you are disciplined (which most people with large debt are not), taking the HELOC to pay off credit cards is wise. I just don't meet many that should because they spend too much and will only reload them up.
quote:That is a good point in that you must solve the credit card spending first. Thanks for sharing that... I know with all of the decisions that the Math is one thing but there is an emotional aspect as well. That is one variable everyone has to try to judge on their own.
First I took unsecured cc debt and made it secured against my home. A bad and unnecessary risk, had one of us lost our jobs shortly thereafter or even if I had been transferred and forced to sell, it could have ended badly. Second, it doesn't solve the underlying problem of cc spending. You have to solve that first. Luckily we learn, the second time our debt got to high, we paid off College loans, cc debt and had two kids in Jr High. And have tried extremely hard to be cash only since. If you have the discipline and lifestyle adjustments to solve the problem, you can pay it off normally and maybe that added expense will be a motivator going forward.
Agree with several above posts. The hard truth is when you rack up $90k in consumer debt, the real problem isn't the debt itself but the spending that got you in the hole. To some extent that includes if the spending was for higher education, because there is no way any degree requires $90k in credit card debt.
If they don't fix the basic math of:
Income - Spending <<< 0
It won't matter where the money comes from to pay off the debt (401k, another loan, inheritance, any other windfall). They will end up right back in the hole.
I've seen it happen to extended family. They use home equity loans or a windfall of some kind to pay off "bad debt" (credit cards) and end up maxed out again in fairly short order.
If they don't fix the basic math of:
Income - Spending <<< 0
It won't matter where the money comes from to pay off the debt (401k, another loan, inheritance, any other windfall). They will end up right back in the hole.
I've seen it happen to extended family. They use home equity loans or a windfall of some kind to pay off "bad debt" (credit cards) and end up maxed out again in fairly short order.
Actually I started buying in 2013 so I still got to recover from the devastation that was 2008-2009 in the stock market before I pulled it. Home prices had come up slowly...but I bought foreclosures so the market was still saturated with those. Maybe I'm just bad at 401k allocation but I tracked what I was in vs the home values, plus cash flow over that period and it wasn't even close. Also my wife is staying home and but she plans to return to the work force eventually. I decided to take the tax hit while on the single income, obviously an unique situation for me.
I realize that housing isn't without risk...and as you point out, though it is labeled as passive income...let's be honest it is work. I never got a call in the middle of the night that a pipe had burst when my money was in the 401k.
I realize that housing isn't without risk...and as you point out, though it is labeled as passive income...let's be honest it is work. I never got a call in the middle of the night that a pipe had burst when my money was in the 401k.
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