It's not right, but is it ok?
November 28, 2012 6:55 AM   Subscribe

Are we in one of the rare situations where cashing out a 401K makes sense?

My husband is on long-term disability. A few years back, when he was able to work, he ended up with a 401K plan that now has $1900 in it. He had forgotten about it, but the company, now under a different name (I think the original company was sold or went under) has tracked him down to find out what he would like done with the money.

We could really use it to pay some of his doctor bills, and a little bit of research seems to indicate that because he's disabled, the tax penalties might not be as bad as they would be otherwise. Are we missing anything? It's not exactly a life-changing amount of money, but paying off some patient doctors or making a big payment to a credit card would really feel great. If we rolled it over into whatever financial instrument you're supposed to use for this situation - a CD, a Roth IRA, what have you (I'd probably ask Fidelity or my bank that question) he would be in no position to further add to the sum of money to keep the investment growing.

I don't know if it's pertinent, but I make about 30K a year and we file our taxes as married filling jointly. I have a 403B account that I contribute to via my work.
posted by anonymous to Work & Money (10 answers total) 3 users marked this as a favorite
FYI, if you take the money, you may pay a 10% penalty for early disbursement-so $190, and then you'll be taxed on it at whatever your regular tax rate is, so figure around 12% or $228. You would have $1482 to spend.

Now, if you roll it over into an IRA, and added nothing more to it over time, in 30 years it will be worth $20,778. (assuming 8% return)

So...that's kind of the the thing to consider.
posted by Ruthless Bunny at 7:14 AM on November 28, 2012 [1 favorite]

The IRS will waive the penalty for a filer with a qualifying disability (see the section "Tax on early distributions").

You will need to have appropriate proof of the disability and file the correct paperwork required by your 401(k) provider.
posted by dhartung at 7:18 AM on November 28, 2012 [2 favorites]

Ruthless: "assuming 8% return"

I don't think that one can assume 8% return these days. I do think you can get the penalty waived.
posted by leafwoman at 7:53 AM on November 28, 2012 [5 favorites]

If your other option is charging it and paying 20% interest, then yes, cash it out.
posted by empath at 7:55 AM on November 28, 2012 [4 favorites]

Ruthless: "assuming 8% return"

In the stock market. Over 30 years. The S&P historically returns 10%.

I was being conservative.
posted by Ruthless Bunny at 8:03 AM on November 28, 2012 [1 favorite]

You should think about the time-value of that $1900. Whats the current rate of interest on your debts? Whats a conservative rate of return from now until your retirement age?

I can't see many ways in which it makes financial sense to pay off the debts today. You've basically laid out emotional reasons why you want to, (which are honorable and kind reasons!). Emotional reasons are perfectly good reasons to do something, but it is something you need to consider.
posted by fontophilic at 8:54 AM on November 28, 2012

You mention a big payment to credit cards. While you can negotiate on doctor's bills and work out payment plans over time, credit card companies tend to be a lot more demanding and pile on interest at a frightening rate. Are these credit card bills the kind that were one time extraordinary expenses which you are paying off slowly? Are you willing and able to ensure that your credit card bills are consistently going down, not up? Would a very pessimistic estimate of about $1,000 be sufficient to make a dent in your credit cards which would lighten the interest burden without leaving you feeling complacent on paying it down as quickly as reasonably possible?

If the answer to those questions are all true, it may be a reasonable idea to pay down your credit cards. The stock market rarely outperforms credit card interest rates. Meanwhile, a lightened burden and paid off cards would leave you in a good position to contribute more to your own retirement fund, hopefully within a couple of years. There is also the fact that if your bills are causing you significant stress which may be impacting your health, having some relief could pay off in ways that interest growth does not consider.

As for the doctor's bills, think about whether you are approaching the state of collections. They would much rather settle a bill for a reduced rate than send it to collections. In a case like that, avoiding the hit to your credit score might be a good idea after all.

Be honest with yourself on this. If you have ever had a tendency to spend on credit in non-emergency situations or know that you would reduce payments on cards to a minimum amount when you see a smaller bill come in just to have that little bit more for right now, paying down your cards could end up being a very temporary relief. Despite my justifications above, this withdrawal is not something to take too lightly. It is only sensible in the case that it is a part of a larger financial plan which is currently succeeding and has every reason to continue successfully. In a way, it is a loan of a different type which you are only accountable to yourself for.
posted by Saydur at 9:03 AM on November 28, 2012 [1 favorite]

Agree with everything Saydur says

Though the market returned 10% annually over the last 30 years, there is plenty of reason to believe that will not occur going forward. Also, stock market appreciation does not net out the cost of inflation, so the real spending power is a LOT less than 10% annually. (Quick example, housing costs where I live have risen approximately 12 times since then). In addition, who knows what the tax situation will be at that time, but it is not unreasonable to think that 40% of your appreciated investment will go to taxes at some future point when you withdraw it. All this to say, neither choice is a slam dunk.

In the big picture, it is not a lot of money. If as indicated above you can withdraw it without penalty and pay down bills with significant interest it is a perfectly reasonable move. When you pay down bills you are in essence locking in a rate of return.

As Saydur notes, if you would use the breathing room to rack up more cc debt, don't do it.
As a general rule, it is of course poor form to touch retirement money. Good luck!
posted by jcworth at 9:37 AM on November 28, 2012

Dave Ramsey suggests building an emergency fund of $1000, then paying off your debts, then building an emergency fund of 3-6 months, then paying into retirement. I don't know whether he would tell you to cash out a 401k, but he might say you weren't ready to put money in, yet.
posted by jander03 at 10:20 AM on November 28, 2012

If you have credit card debt, the choice is not between $1482 now or $20,778 in the future. The interest rate on those credit cards will be higher than 8%. This means that if you do NOT cash it out, the $1482 debt on your credit card that you WOULD have paid off will snowball to $18,885 in 20 years time (assuming interest of 14%, which is about average for a credit card in my experience). I don't understand how an IRA works, because I am not American, but I assume there is some sort of government funds matching, which is how you end up with $20,778 if you put it in one.

So if you don't cash it out, you'll have $20,778 in 20 years time, minus $18,885 in debt, which leaves $1893. Given inflation, that's not all that awesome. I think you'd benefit more from the piece of mind withdrawing it now and paying a little debt off would give you.
posted by lollusc at 5:25 PM on November 28, 2012

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