Don’t touch that 401k!

With a presidential election days away, turmoil in the markets, and the government set to spend nearly a trillion of our dollars “fixing” a mess the government created—investors are understandably worried, even afraid.

Recently, one worried reader asked the following:

It’s October 11, 2008. A time of recession, bailouts, economic collapse, and massive government debt. I am 54 years old. My wife is 46. I have closed out my stock funds in the 401k and have it sheltered in a money market. I am thinking about pulling money out of my 401k to pay down my mortgage.

I think I will get a greater return on my money than I will by being in just a money market fund. the mutual funds were losing lots of money. One of my funds was losing 41% of it’s value. We also have a lot of credit card debt. I owe 18,000 and my wife owes 30,000. Plus she owes $20,000 in student loans. Plus I have a son in college.

I know that in normal times pulling money out of a 401k wouldn’t make sense, but now the economy is about to collapse I think that it does. I can make a guaranteed $130000 in saved interest if I do that. I don’t think the stock market will be back any time soon. I favor paying down the mortgage over the cards because it will insure I won’t lose my home that way. Then I can work on the cards. I think our jobs are pretty safe. We just are overloaded with debt. I am only 3.5 years along on a 30 year mortgage.

I haven’t done this yet, but I think it makes sense. It looks like just leaving the money in place will be a losing proposition. They say even money markets aren’t safe any longer.

What do you think? -Concerned

 

Yes—the stock market isn’t pretty. Last week the S&P 500 experienced a 18.2% drop and was down 38% for the year. Nerve wracking? Certainly. But the following Monday (10/13/08) the S&P 500 gained 7.5% back only to lose it again. Stocks can be extremely volatile.

Yes—earlier this year would have been the perfect time to have switched from stocks to something safer. But, how would you know when to jump back in? Successfully timing the market is more difficult than most people think. The vast majority of professional investors fail to beat the market.

Bailing on the market now and handing the government half of your remaining savings would not be a good idea. An early withdrawal now will cost you dearly. The withdrawal will be taxed at your tax bracket plus a 10% early withdrawal penalty.

For example, the 41% drop would have turned a 100k balance into 59k. An early withdrawal would then trigger a 10% penalty tax, added on top of your tax bracket, leaving a mere $38,350 for debt repayment. (assuming the 25% bracket)

That’s a heavy, guaranteed price to pay just to avoid the ups and downs of the stock market or the low returns of a money market fund. Instead, a better strategy would be to take a step back and then invest according to a written and well thought out asset allocation plan that relies on index mutual funds and is compatible with your tolerance for risk.

A good asset allocation plan will diversify your investments, providing stability during rough periods (like the present) in the stock market. You should work with a professional fee-only financial planner to develop your investment strategy, but there also are many excellent books on investing successfully. The Coffeehouse Investor and The Four Pillars of Investing are two of my favorites (read them in that order too).

Paying down debt is always a good goal

I am a big supporter of short mortgages, but mortgage prepayment needs to be part of a bigger strategy to avoid debt in all of it’s forms.

Right now, your biggest challenge isn’t stock market fluctuations or a downturn in the economy, the challenge is changing your spending habits. You and your wife need to sit down and work out a written budget where every dollar has a name. The budget needs to cover all of the essentials: mortgage, utilities, food, insurance, & minimum payments.

Then, set aside a thousand or more towards an emergency fund. It’s essential that you have some money to fall back on because you really need to tear up your credit cards. Once you are debt free, you should work towards an emergency fund equal 3-6 months worth of expenses.

Next, take what’s left over each month and put it towards the $18k credit card (or the smallest balance if it’s spread across several cards). You want to throw everything you can at this debt to make it disappear fast. Once it’s repaid, repeat the process with the next smallest credit card debt.

To turn this ship around faster, one or both of you need to get a temporary, part-time job. Life is going to be rough for a few years, but the inconvenience will be temporary. After all, you’re making an investment in your future happiness.

You also might want to consider talking to your son about shouldering more of the financial responsibility for his college education. Helping with college expenses is a great goal, but you won’t be doing anyone any favors if you drown in debt to spare him the indignity of working his way through school.

Retiring debt is the first step to a happy retirement

If you don’t get aggressive right now and show debt the door, you’re going to be looking at a lifetime of working—into your seventies and beyond. Retiring is next to impossible when you’re servicing debt.

For more information and inspiration about ditching debt, I’d recommend you tune into Dave Ramsey’s national radio show. He’ll put you and your wife in the right frame of mind to begin working for yourselves instead of working to feed the credit cards.

P.S. Don’t fret about the economy. It’s slowing down right now and life will get a little rough for some people. But the downturn will be temporary; it always is despite what the talking heads on TV tell you. The best way to prepare is to (1) pay down all of your credit card and car debt, (2) fund a large emergency fund, and (3) then keep developing your professional skills. Businesses are always interested in potential employees that possess valuable, in demand skills.