Don’t Raid Your 401(k) to Make Mortgage Payments
Wednesday, 4th June 2008 (by J.D.)This article is about Choices, House and Home, News, Retirement
What’s worse than not being able to make your mortgage payments? How about tapping into retirement savings to make ends meet? National Public Radio’s Morning Edition ran a story on Friday about the growing number of people making “hardship withdrawals” from their retirement plans. From the story:
“It’s a terrible choice on so many levels, because we shouldn’t be messing with our futures for the present,” says Jane King, a financial planner who serves as president of Fairfield Financial Advisors in Wellesley, Mass. For the first time in her career, she’s been getting calls about hardship withdrawals. King blames the housing market. She says until now, if anyone had surprise expenses, they’d normally take out a home equity loan.
“People had wiggle room by borrowing on their houses, and it just isn’t there anymore,” King says. “So the 401(k) or the retirement plan has become maybe the next best thing.”
Alicia Munnell, director of the Center for Retirement Research at Boston College, says the real price of cashing out retirement savings early is not the penalty, but the loss of the decades of interest and growth that those savings would have earned.
If drawing on retirement savings to salvage present-day personal finances is so bad, why are people doing it? Because the future is “amorphous”, says Ashley Kennedy, a struggling homeowner who was interviewed for the story. What matters most to Ashley right now are the looming monthly payments.
Why is raiding your 401(k) to pay current bills a bad idea?
- If you take an early withdrawal from your 401(k), you not only have to pay income tax, but also a 10% penalty.
- Worse, when you spend your savings, you’re sacrificing the compound growth that might have achieved in the decades to come.
- After a hardship withdrawal, most employers won’t let you make a tax-deferred contribution to your 401(k) for at least six months.
Some experts say that if you’re really desperate to use the money in your 401(k), you’re better off taking a loan from the account than making a permanent withdrawal. You’ll lose potential earnings while the money is out of the account, but you won’t be subject to taxes or penalties. But even this isn’t a good idea, and should only be used if all other options have failed.
Don’t compound a bad situation by making another poor choice. Your retirement savings are a safety net for the future, not for the present.
[NPR's Morning Edition: Tapping 401(k) now may cause financial pain later, via Matildaben]
When we got married, we both opened IRAs and began contributing $50 a month for each of us. Oh, how I kick myself about not continuing this! Within a couple of years we had to cash them out to cover emergencies that came up, because we had no emergency fund. It did save us from having to use credit cards when we needed bailing out, but I think we are paying more in what interest could have been gained than what we would have paid on a credit card for a few months. It is hard to know, but I do know that we made very little money at the time and wanted to stay out of debt. We made what we thought was a good decision at the time. It was just 2 years ago that I finally opened another IRA and started setting aside money for my retirement again. I missed 10 years. Ugh! What I wish I had known then. Great article, I hope people listen to this advice!
I think this is a point that needs to be made over and over again. While I don’t yet have a 401(k), I have just ventured out into the working world, I know that I will consider any money in the account to be lost money until I retire and start using it. Although I also don’t have a mortgage right now either so I suppose I can’t really say what I would do one way or another if I was in such a position.
While I agree with the premise of this post, I doubt it matters. The folks in the foreclosure mess are not the type to heed good advice. These are people who kept refinancing every time housing prices in their neighborhood went up wiping out their equity and spending it on wants rather than needs. For the most part, this “crisis” isn’t affecting responsible people who live within their means. Likewise any bailout will not solve things for the irresponsible as long as they continue to conduct their financial affairs in the same manner.
I agree with this advice, but I wonder what people who are faced with losing a house should do (besides all the conventional advice, spend less, earn more, have an emergency fund, etc.)? I think its easy to think of 401k as ‘present’ money because most of us put that money aside (also known as saving it) so its not surprising that when in a real emergency one would look to that pool of money.
As more and more of us are responsible for funding our own retirements via 401k this is going to be a bigger and bigger issue. The future and retirement feels very far away for many of us and as such its the first thing to be cut from the budget.
Also it’s a bad idea because you have to pay tax on it twice, right? You pay the tax on the money when you take it out of the 401(k), and then you earn money, pay tax on it, and then put it back into the 401(k). So the money in your 401(k) has been taxed twice, plus the 10% penalty. That’s like getting a loan from a loan shark. That could be like an 85% rate of loss, couldn’t it? Very bad idea.
When she proofed this post the other night, Kris told me: “You’re missing a very important piece. What else can people do?” That’s a damn fine question, and one for which I don’t have an answer.
The obvious answer is to avoid the trouble in the first place. That is, make smart choices early so you’re not forced to make difficult choices later. As a person who has made some very dumb choices in his life, this is easier said than done.
Based on my current reading, and based on the news I see every day, it seems that so many financial problems — both on a micro- and a macro-level — come from people believing that they can somehow get rich quick, that they can go against the conventional wisdom because they’re smarter than anyone else, or because “everyone else is doing it”. When a person is only being contrary, they only hurt themselves. But when they go along with a herd of people hoping to get rich by bending long-standing “rules”, then everyone suffers, even those not making the poor choices.
In this post (and this comment), I don’t really have anything to add or suggest. I’m merely trying to relay the advice of experts, advice that I’ve come to believe is very very good.
I would agree with the advice, but since even J.D. doesn’t have an answer for “what else should you do?” it seems somewhat bogus.
My take on it is this:
Yes, avoid getting into the situation where you need to withdraw from your 401(k) to make ends meet. But if you’re in that situation, its not the craziest idea in the world. Lets assume that your options are foreclosure/bankruptcy, credit card debt, and taking from your 401k. Credit card debt (typically) is HUGELY expensive. Foreclosure (or bankruptcy) would be awful.
Credit Card Debt: I would do this if I needed a relatively small amont of money, and knew I would be able to pay it back within a few months.
Bankrupty/Foreclosure: I would do this if I was completely screwed on the mortgage. Since (I think) debt collectors and bankrupty court can’t come after your 401k, you’re better off giving up on the house.
401k Withdrawal:
If I was living hand-to-mouth and needed to either make either a single small payment or to withdraw a very small amount per month to get buy, I would do that. Its bad, but I don’t think its worse than either credit card debt or foreclosure.
Lets face it, most people in this situation can’t sell the home for the amount owed on it.
JB wrote: I would agree with the advice, but since even J.D. doesn’t have an answer for “what else should you do?” it seems somewhat bogus.
I don’t necessarily think it’s bogus advice. It’s good advice. But I do agree it’s like saying “don’t drive too fast” when your car’s breaks have given out.
If the situation were isolated, the person in trouble should decide to sell their house immediately and downsize to a smaller home or at least one with a more manageable mortgage payment. However, in these times, with this housing market, that’s not an option.
I have a friend whose husband lost his job totally unexpectedly a few weeks ago. The FIRST thing he did was withdraw all of his 401K and pay off their car, pay ahead 6 months on their mortgage, and pay a few more things off. He still has 401K funds left, but right now they are just sitting in a savings account. This fellow is 60. Bad decisions on so many levels.
When my son was 4 months old my husband was laid off - I was only working P/T because my job couldn’t pay me to return to F/T after maternity leave. It took me a year to find a F/T job. We could barely pay our bills and buy food. We had to go to the food pantry. We went to see if we qualified for WIC so we would at least have basics for myself and my son but we were turned away. Why? Because of the ‘assets’ we had with my pension at my job. We ended up asking my MIL to move in with us to help us with food and bills, but I still am bitter that we would have had to raid my retirement so that we could buy milk and bread.
IMO, this is a compelling reason to contribute to a Roth IRA if you are eligible. Roth contributions can be withdrawn penalty-free at any time for any reason, so a Roth is a viable option as an emergency fund. If you never need the money, great, you can enjoy it in retirement!
In fact, it doesn’t make much sense to set aside emergency funds in a taxable bank account until you’ve maxed out the Roth (keep your money in a money market account inside the Roth until you’ve built up enough to serve as emergency reserves).
If the inability to make a mortgage payment really seems to be a one-time (one month) problem, what’s wrong with just skipping the payment that one month (or paying as much as you can)?
Doesn’t it take months of missed payments for the foreclosure process to begin? I would think that if you skipped a payment and then picked back up the following month, you may incur some penalties and interest expenses, but it’s better than the 401(k) withdrawal.
If making the mortgage each month is an ongoing difficulty, then it’s time to sell the house. If the market sucks and you can’t sell, you might just be better off walking away or getting foreclosed on.
from the original post: “Some experts say that if you’re really desperate to use the money in your 401(k), you’re better off taking a loan from the account than making a permanent withdrawal. You’ll lose potential earnings while the money is out of the account, but you won’t be subject to taxes or penalties. But even this isn’t a good idea, and should only be used if all other options have failed.” Maybe, but during these troubled economic times, remember that if you get laid-off, that 401-k loan becomes due and payable now. If you don’t pay it back within the time limit (30 days? I don’t remember), it is considered the same as a withdrawal and taxed and penalized the same. So, really bad news as tax time rolls around - the IRS says pay up - taxes and penalty. When you are out of work, it’s a bad time to have to come up with a big chunk of money. The only (small) saving grace in the loan versus withdrawal scenario is that any payments you have made will lower the loan balance, so you’ll pay a bit less taxes/penalties, depending on what your remaining balance is.
The only time Dave Ramsey ever tells anyone to withdraw from a 401K or other retirement account is specifically to avoid a bankruptcy and in some cases foreclosure.
I think if you don’t have any better options, then using some of your retirement savings is not the worst thing in the world.
As JD and other mentioned the real problem is that these people got themselves pretty far in the hole to begin with. There may not be any clean and pretty methods to get out.
Mike
This kind of increasing trend may be bad, but it does go to show that the work you’re doing here in educating people on personal finance is much needed, and I hope, much appreciated. Thanks, JD.
If we had some effective action from Washington on the whole foreclosure aspect, you would be able to withdraw penalty free from your IRA/401k’s to pay off the mortgage.
I agree with Richie. If it is a temporary situation, call the bank and tell them you can’t pay for a month or two. They aren’t going to start foreclosure for a temporary situation; not when they are overwhelmed like they are now.
If it *isn’t* a temporary situation, bite the bullet and let the house go, instead of draining your IRA and *then* letting the house go.
the really bad situation is when you consider raiding your 401k for healthcare costs… those aren’t optional and you can’t get out of bad health.
I’m of the humble opinion that using your savings to pay down your mortgage is a bad idea…
Emma (#18) makes a good point:
“…bite the bullet and let the house go, instead of draining your IRA and *then* letting the house go.”
Call your mortgage lender and negotiate the terms of your mortgage.
I know, I know…you tried and that didn’t work. But at least you got it on record and you tried. If they agree to reduced payments for a couple of months great! Again, you got it on record and you tried.
A client of mine called his mortgage lender to discuss making reduced payments of the next couple of months…they agree to 4 months… Since then he’s stopped making payments (payments are about $5,300/month). He’s been living in his home free for 5 months now and probably has about another two months left before they officially foreclose.
Take the $5,300 in monthly savings you’ve been accruing and plan on where you’re going to live next. It’s tough yes, but you still got your retirement saved up. The alternative might have been that you depleted your retirement and lost the home anyway.
I’m starting to be open to the idea of buying my own place ( condo/town house ). I plan on starting the process of educating myself this year. I know nothing.
In my field interesting jobs tend to dry up after 1-2 years. I’m terrified of not being able to make mortgage payments.
I realize this is a bit irrational. It isn’t any different then being out of work and not being able to pay rent. If I can’t pay my mortgage and my house gets sold I can at least get some money back.
This blog entry relates to one of my big fears about borrowing to get my own place.
Is there something else I can do or think of to prepare for a world where I may work an unstable job while making mortgage payments?
I already have an emergency fund to let me coast a couple of months.
I agree with Emma (#18) if it is a temporary situation then try to save the house. But be realistic, can you really consistently make the mortgage payments? Also, given the current market prices, do you have any home equity left? If the answer to both is no then I would look into a short sale as an alternative to foreclosure.
From Wikipedia:
“A short sale is when a bank or mortgage lender agrees to discount a loan balance due to an economic hardship on the part of the mortgagor. The home owner/debtor sells the mortgaged property for less than the outstanding balance of the loan, and turns over the proceeds of the sale to the lender in full satisfaction of the debt. In such instances, the lender would have the right to approve or disapprove of a proposed sale.”
Why would a lender agree to a short sale? Because foreclosure is VERY expensive for the lender and they would likely get market price (or less) for a foreclosed property anyway. Given the huge number of foreclosures I bet that banks would be much more willing to do a reasonable short sale.
-Rick Francis
I find this very interesting. I am a firm believer in a 401(k). I don’t think you should reach into your 401(k) to pay off your mortgage either, but there is a point where I believe that maybe not contributing to your 401(K) and paying off your debts is more important and in some rare occassions I actually disagree with this article. I believe that if your debt is so bad that your looking at forclosure and bankruptcy you should pay off your debt with your funds.
I agree that it is not a great idea, but it beats losing your home near the bottom of a real estate swoon.
I honestly don’t see the difference between withdrawing from a 401K and taking out a home equity loan. In both cases, you’re decreasing your net worth and effectively borrowing money that you will have to pay back later. And it doesn’t make a lot of difference to the bottom line whether you’re paying interest on debt or foregoing interest on savings, except where the interest rates are different.
Withdrawing from a 401K may be worse because of the penalty and income tax, but a home equity loan is hardly a good alternative. The good alternative is to live below your means, build up a cushion and prepare for rainy days. The whole point of an emergency fund is so you don’t have to do something worse like take out a loan or raid your retirement savings.
Instead, we’ve seen the largest increase in consumer debt in history during a time of economic growth. The fact that the debt spigot has been suddenly shut off is not the problem, the problem is that people were relying on ever increasing amounts of debt to maintain their lifestyles. Which means that by definition such lifestyles are not maintainable. Eventually, people will be forced to live within their means. If they start early, they’ll be fine, but the longer they wait the less they’ll have. If they can’t take out a HELOC, that means they no longer have any equity in their home. Eventually they will have nothing in their 401K. When that’s gone they’ll max out their credit cards, get behind on bills, borrow from friends…. But at some point, no one will lend them money anymore, and they will have to live within their means. Or in fact, below their means, to pay back all the debt.
I am self employed with a small business that did not do well enough to warrant me paying taxes this year. I pay $11,000 a year in rent. I saw a house for sale that was older and needed minor doable repairs and the price was $33,000. A bank will not give me a mortgage due to my income history. I plan to remove the money from my 401k to buy the house in full and pay the taxes and penalty on the money. I will incur an expense but remove the amount I pay yearly for rent. In addition, I think my 401k investments will decrease in value due to poor stock market performance coming soon. In addition, when I need to remove the 401k as I reach retirement age ( I am 54) millions of others will also be doing the same and my 401k may be worth even less due to many sellers and not enough buyers.Taking money oyt now to have a paid for roof over my head is a good idea. Is my plan unreasonable?
i am currently attempting to figure out if i should take out a partial distribution from my IRA in order to pay off or at least eliminate a big chunk of a personal loan i have at a high interest rate. i am relatively young and would find much immediate emotional relief from a significant debt reduction.
what do others think i should do? http://tinyurl.com/6jnsdl