Sunday, April 1, 2012

When Should You Tap Into Your 401(k) or IRA?

When Should You Tap Into Your 401(k) or IRA?

The short answer is:  NEVER, at least until age 59-1/2 when you can do so without tax penalty.  But even then, you should avoid using this money unless you are RETIRED.

In recent years, we are hearing a lot of sob stories in the media about people making really, really bad financial choices and one of them is to tap into a 401(k) to pay off debts.

The typical scenario goes like this:

Joe and Susan buy a townhouse in Florida in 2006.   They waited for years, convinced the market would top out or the bubble burst, but finally they got tired of renting.   Susan was tired of her friends, who all had new townhouses or homes and snickered at her for "renting". 

"I have fabulous new granite counter-tops, Susan!" one of them chirped, "It must suck to be poor!"

Yea, women are that cruel to each other.

Joe's buddies regale him with how rich they are - on paper, now that the house they bought last year is worth 30% more.  "I'd sell it and cash out," one says, "but then where would I live?  Besides, it will just keep going up in value, so why sell at all?"

So Joe and Susan talk to a Real Estate Agent, who shows them some wildly overpriced town homes and introduces them to a friendly mortgage broker, who tells them about some great new "products in the mortgage market!" such as a the new "pick-a-pay loan!"

The broker runs the numbers for them and shows them an initial monthly payment they can afford.  Joe and Susan, living the cash-flow lifestyle just look at that monthly payment, and don't think about the overall transaction costs - or the potential for rapid escalation of the monthly payment.

Joe's nagging concerns are soothed by the Real Estate Agent.  "If the payment goes up too high, you can always refinance at a fixed rate!" she says, "Or, you could sell the home and cash out!"

So they buy the house.  Can you count how many serious financial mistakes they've made so far?

1.  Overpaid for a house in a bubble market.
2.  Bought for emotional reasons, not logical ones.
3.  Did not "do the math" to see if it was cheaper to rent.
4.  Looked at monthly payment (cash-flow) instead of overall cost (net worth).
5.  Assumed that something that shoots up in value will continue to do so.
6.  Listened to financial arguments made by people hoping to profit from the transaction. name a few.

Well, you know how the rest of the story pans out.  No, houses in Fort Lauderdale can't go up in value by 30% a year forever - or even for more than a year or two.   2009 happens, Joe loses his job, the shit hits the fan, and they can't make the mortgage payment.

Why?  Well, a year after they closed on the house, the County assessor re-assessed the house at full market value, and their property taxes went from $2000 a year to $8000 a year, significantly increasing their mortgage payment.

Then a set of back-to-back hurricanes jacked their insurance rates through the roof - to $2000 a year.

Then, the ARM rate on the loan kicked in, and the "introductory rate" for the first two years evaporated, and they had to pay full price, at an unattractive 7.5% interest.

So what do Joe and Susan do?  They make even more horribly bad financial decisions.

At this point, Joe and Susan could have walked away - calling a lawyer, declaring bankruptcy, doing a short-sale with the bank, and then moved on with their life, albeit with a damaged credit rating.  It is hard, but the net result is, they end up renting again - back where they started - and got to live in a house they could not afford, for a few years.  If they clean up their finances, chances are, they might be able to buy back that same house, in a few years, for far less than they paid for it - on a 30-year fixed note, this time.

But Joe and Susan don't want to be seen as "giving up" on their house.  Moreover, Joe is convinced that the market will quickly turn around, and they will be able to sell the house at a profit.  So they do the dumbest thing you can possibly do.   They start cashing in money from their 401(k) to make the mortgage payments and to pay bills.

This approach "works" for a few years, but with only $150,000 in their 401(k) account, they burn through that money rather quickly.  And moreover, this is money that took them two decades to earn.  And worse yet, they take the money out in 2009, at the market's nadir, so that the end up "Selling Low" as well.

IRA and 401(k) money is generally protected in bankruptcy and this is a good thing.   You may not be able to shield this money from the IRS, but if you end up $100,000 upside-down on a house, as Joe and Susan did, well, you can declare bankruptcy and walk away with your nest-egg intact.

So now, three years later, Joe and Susan have managed to "hang on" to the house, but with late payments and the like, their credit rating is pretty shot.   Worse, the 401(k) is pretty tapped out.   Joe found a new job, but at far less money that the dream job he had before.   They get behind on the mortgage payments, and, well, the bank forecloses.

Of course, this will take a year or two to complete, but eventually, Joe and Susan will be forced out of the house.  And now, not only are they bankrupt, they have no savings left for retirement.

Never, ever tap into your retirement savings for something as trivial as paying off debts.  The idea that you will be able to "turn things around shortly" is usually an illusion.   If you are facing severe financial problems, it is time to cut back.   And you are far better off going through a controlled bankruptcy than to let it happen only after you are utterly tapped out.

Unfortunately, I read a lot of stories in the press - these sob stories - that have the tag line, "And Mr. and Mrs. Schmuck are so bad off, they have had to tap into their retirement savings!"

This means that a LOT of people will be approaching retirement with no savings, which is bad.   And these types of articles provide the poor normative cue that retirement savings IS something you can tap into, for emergencies.

But I disagree.   Taking your only asset shielded in bankruptcy and using it to pay off debts that can be reduced or wiped out in bankruptcy  makes no friggin' sense whatsoever.

Talk to a bankruptcy attorney, if you are thinking of tapping into your IRA or 401(k).  And a real attorney, not a "debt relief" agency or a "stop foreclosure now!" con-job.

Unfortunately, this advice is too late for many.  In 2012, there are a lot of folks who are about reaching the end of their retirement savings, all so they could "stay in the home" for 2-3 years more.