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How "Old" 401(k) Funds Can Get You Out of Debt Quicker…

Are you one of those people who has changed employment and still has money sitting in an “old” 401(k)?  I want to give you options to think about in terms of how to use this money rather than just leaving it sitting there doing very little to benefit you. 

Take a look at the following illustration. It shows an employee putting money into a 401(k) “vault” of sorts:

The reason I call the 401(k) a vault is because money in this type of account is sort of locked up. It’s not liquid and can’t be used very easily. Basically you have very little control over this money. As you examine this illustration further, you’ll see that there are cracks in the vault, which represent the expenses of keeping your money in the 401(k) vault.  The vault does not offer protection from losing the money, as it is most likely invested in the market or mutual funds, which have volatility.  And notice when you retire and start drawing down on this 401(k) Uncle Sam is there, positioned to take a share of everything that you’ve put into the fund, plus any amount it has grown.

Now take a look at a couple I’ll call Mark and Joyce and their “Get Out of Debt” report, which is based onPower Down principles of quick debt elimination:

If Mark and Joyce will control spending so as not to keep getting into debt, they can have all debts paid off in less than 10 years.   It demonstrates how Powering Down your debt will get you debt-free in about 9 years, including your mortgage.

Now combine these two concepts of how the 401(k) locks up your money with the Power Down principle of getting out of ALL debt in less than 10 years. If Mark and Joyce were to consider taking all the money in an old 401(k) to pay off debts with higher interest rates, this could jump start their debt elimination considerably. Now of course, if they are younger than age 59.5 then they will have to pay a 10 percent penalty on top of the income tax due, but I don’t think you should be afraid of the 10 percent penalty because it’s less than those  high-interest rate debts you would use the 401(k) money to pay off.

Here’s how it could work:  

  1. Roll your 401(k) money into an IRA, so you have control.  Consider a credit union’s IRA savings account and remember earning interest is not the point. 
  2. Early in the year, like January or February, consider taking out a large chunk (in this example, I’ll use $10,000) and pay off credit card debt.  Taxes and penalty on this collapse of the 401(k) money are not due until April of the NEXT year. 
  3. Using this example, you would pay off $10,000 worth of high-interest debt (I’ll use a 22 percent credit card) and save that 22 percent for one year, which would equal $2,200.

Viola! You have just paid off a high-priced debt AND you are saving a ton of interest you would have had to pay to the credit card company. This suggestion would save you from paying interest of $6,500 on the credit card if you were to pay it off over a 5-year period, or much, much more if you never paid off the card at all!

So if you have an OLD 401(k) consider “using” it.  It does not have to stay in the “vault.” As it sits in the “vault” fees are being assessed, the market can decline, and in the meantime you owe $10,000 with a 22 percent interest expense on credit card debt — you’re basically going around and around in circles instead of getting on the road to total debt elimination.

While this is a great idea, I want to CAUTION you.  If you do not control your spending and therefore cannot save the monthly credit card payment of $275, in this example, you had better not touch the 401(k).  It makes no sense to pay off debt in this way where you will pay a bit of a price to do so if you are just going to get into more debt.  

Contact me with your debt information and I will prepare a Power Down report for you at no cost that will show you when you will be completely out of debt: peter@moneymastery.com.

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