Letter Re: Surviving Financial SHTF and Becoming Debt Free

Hugh,

Regarding K.D.’s article on becoming debt free, a 401K loan should be the last resort in most cases. “Paying ourselves interest” sounds like a fantastic deal, but it is not that simple. What many do not realize is that loan payments into a 401k (typically from payroll deductions) are made from after-tax dollars. When those dollars are later withdrawn from the 401k, they are taxed again. So, the dollars you “pay yourself interest” with will be taxed twice. Assuming the lowest federal bracket of 15%, that “additional 3.25%” the author mentions going into his retirement account will all be lost once the total of 30% in taxes those dollars will be subject to are factored in.

Also, should the 401k borrower find themselves no longer employed, the loan will still need to be paid back. Failure to do so would cause the amount of the loan to be categorized as a distribution, taxed at normal income tax rates, and depending on the borrower’s age, a 10% penalty could be assessed.

Additionally, for the average (not wealthy) person, the interest on a second mortgage is probably tax deductible. Again, assuming the lowest tax rate, 15%, the effective interest on the author’s mortgage drops from 6.25% to 5.31%.

I commend K.D. for successfully righting his financial ship and sharing his story. Hearing about the success of others is a good way to keep plugging away on one’s own journey. The order he tackled the debts was correct, and building up an emergency fund at the same time is much easier said than done. However, for most people, using a 401k loan to pay off a relatively low interest rate tax-deductible mortgage would be extremely unwise. If borrowing from the 401k is the only way to avoid foreclosure, sure. Borrowing to escape from crushing credit card interest, maybe (assuming one is not going to go on a spending spree with the newly available credit balances). I cringed when reading the final part of K.D.’s story when I learned he took additional loans to pay off his primary mortgage when his balance was low enough that 90% of his payments were going to principal. That ratio would have put him about 2½ years away, at one payment per month, from paying off his mortgage. There is great value in being debt-free, but factoring in the tax consequences of all those 401k loans would be a sobering experience.

This site is a great resource to learn how to best prepare for when things go wrong. When doing so, planning for taxes and retirement should things NOT go wrong should be part of the process. – C.C.

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