401k Penalty

401k or pay off credit cardI’ll often work with a family ready to reduce their debt burden and discover they are also putting a few hundred dollars a month into the company 401k plan.

When I ask them why they are saving with a 401k, the most common answer shows a concern for the future. It is important that they save for retirement or their kid’s college. Being rid of their debt is an important goal – but they also feel the need to think of the future as well. The most common vehicle for saving is the company 401k plan.

The good news is that they understand the value of providing for their future. The bad news is that they don’t realize they may be setting themselves up for failure. Let’s consider an example: A successful family is saving $500 a month in a 401k plan. At the same time, they are paying $500 off to a credit card. This family – at best – is treading water.

Important Questions

To make the point, I’ll often ask the client three questions:

  1. What rate of return are you earning in your 401k? (most people don’t know specifically)
  2. What tax rate will you pay on the money in your 401k? (there is no way to know this because their plan will be taxed in the future)
  3. Is the money in your 401k exposed to market risk? (unfortunately, this is the easy one because the answer is ‘Yes’)

So the next question is this: ‘If you could get a 12% return on your money that was risk-free and tax-free, would that be a better option than your current 401k?’ Most don’t hesitate and say ‘Of course! where can I find that deal?’

The answer is simple, and startles many of my clients. ‘I tell them to pay off their credit cards before doing anything else. By paying off their credit card will save 12% interest (or whatever the rate is). Using your savings to extinguish the debt moves you quicker to that payoff point.

They’re astonished. They never thought of it that way. Their faces start to brighten.

But What About Matching Funds?

But then they remember the company’s matching funds and most are hesitant to give us ‘free money’. So I ask one more question. ‘What if my matching funds were greater than your 401k matching funds – wouldn’t you want the larger amount?

‘Of course,’ they’ll say, ‘but you don’t have matching funds….do you?’

“In most cases, absolutely!” I inform them. The key is to significantly reduce my client’s time in debt. In most cases, by shifting future savings in their 401k to debt retirement – until that job is done – the benefits are significant. Savings in interest payments generally outweigh the lost earnings and even the lost matching funds. Those saved interest dollars spend just as well as the company’s 401k matching dollars – arguably better since they’re tax-free and can be used before retirement without penalty.

Here is the catch: Each case is different. So taking any action, it is important to prepare a report based on each client’s own information. The report is free and details exactly what can be done. At that point, the decision is theirs to make.

Those who want to get ahead financially are resolved to become as informed as they can be about how money works. At Live Interest Free our job is to provide financial wisdom that can impact your world. If you’d like to see how this might work for you, just let us know – we’re here and happy to help.

 

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