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Mark Cappel

UpdatedJun 1, 2010

Should I cash-out my retirement account to pay-off my debts?

I'm considering cashing out a $24,000 retirement account that my former employer is making available. After taking the 20% taxes and 10% penalty, I would have roughly $17,000. I do not have a high level of debt, but have a mortgage with roughly $31,000 left to pay, a MasterCard that I try to pay off each month which I generally use only for gas and essentials and does not usually run more than $300 a month, a home improvement loan with roughly $4,000 left on it, and one other credit card that has roughly $1,000 on it. However, I am living paycheck to paycheck, bringing home on average between $2300 and $2400 a month. I have only $2,000 in a money market account and a 457 deferred compensation account with my employer. I estimate working another 15 - 17 years. I would like to use the cash out to pay off my home improvement loan and bolster my money market account so that I have cash available for emergencies. Someone mentioned a home equity loan, but I am nervous having a loan against my home, especially because I anticipate needing a new car within a year. To me, this seems like a good move because I could lower my debt and pad my savings without adding more debt. Am I wrong?

In the interest of full disclosure, I want to acknowledge my bias against taking an early distribution from 401(k) and similar accounts. I feel this way for two reasons. First, you mentioned the 10% penalty tax. Second, the money in pre-tax retirement accounts was set aside for, well, retirement, and you may have other options for handling the debt.

Let us look at some numbers. Assuming you retire in 17 years, and make no additional contributions to the retirement account. With a 5% annual return, the $24,000 you have today will grow to $55,000 by the time you reach age 67. Now let me add one hypothetical fact. Let us assume you make a 4% annual contribution to this account. For most employees, a 4% contribution to a 401(k) or similar account is unnoticeable because the contribution is offset by the decrease in taxable income. In other words, the contribution is free money. With a 4% contribution and a 5% return, the miracle of compound interest yields a $107,000 account balance by the time you attend your retirement party. My question for you is, "Do you want $17,000 today or $107,000 at age 67?"

I dislike a home equity loan for a person nearing retirement age, so I want to take that option off of the table.

Regarding your debt, you do not mention the interest rate you are paying on your senior or junior mortgage. Regarding the junior, if you are paying in the 10% or higher range, then my objection to invading your retirement account softens. If you are paying a high interest rate on this loan, then consider receiving a distribution large enough to extinguish this debt plus the second credit card.

Alternatively, if your employer is requiring you to close this account, I strongly urge you to consider rollover.

I hope this information helps you Find. Learn & Save.

Best,

Bill

Bills.com