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Dave Says: Don't cash out your 401(k) to pay off debt

Published: Sunday, May 4, 2014 5:30 a.m. CDT

Dear Dave,

I’m 23, transitioning jobs, and I make $32,000 a year. I have $11,000 in a 401(k), and about $15,000 in debt. Should I cash out the 401(k) to pay down my debt?

– Cody

Dear Cody,

I don’t think so. When you take money out of a 401(k), they charge you a 10 percent penalty, plus your tax rate. Your tax rate is about 20 percent, so that means you’re going to take a 30 percent hit.

While I love dumping debt, your idea would be kind of like saying, “I want to borrow $11,000 at 30 percent interest to pay off my debt.” That doesn’t make a lot of sense, does it?

I never tell folks to cash out a 401(k) or IRA to pay off debt, unless it’s the only way to avoid foreclosure or bankruptcy. You’re not facing either one of those situations, Cody.

So my answer is no.

– Dave

Dear Dave,

What do you think about making bi-weekly mortgage payments?

– Jeremiah

Dear Jeremiah,

I think it’s an awesome idea. By doing that, you can pay off a 30-year mortgage in about 22.8 years, on average, depending on the interest rate.

However, I would never pay someone a fee to set up bi-weekly mortgage payments. All you do on a bi-weekly schedule is make half a payment every two weeks. Since there are 26 two-week periods per year, that equals 13 whole payments. It’s nothing magical, and it’s not difficult.

Go for it, Jeremiah. Get rid of that house payment as fast as you can. Just don’t pay extra fees to make it happen.

– Dave

Dear Dave,

I owe the IRS $6,000, and currently I’m making monthly payments. Should I roll this debt into my debt snowball, and then really attack it when it gets to the top of the list?

– Jared

Dear Jared,

My advice would be to put the IRS at the very top of your debt snowball. Usually, when it comes to paying off debt, I advise people to arrange their debt snowball from smallest to largest, then start with the smallest one and work their way up. This doesn’t always seem to make mathematical sense, but the truth is personal finance is 80 percent behavior and only 20 percent head knowledge.

Paying off some small debts quickly energizes you and gives you motivation. It makes you feel like you can really do it. Besides, if you were such a math genius, you wouldn’t have debt in the first place.

But the IRS is a different animal altogether. Their interest rates and penalties are ridiculously high. Plus, they have virtually unlimited power to collect.

So put them at the top of the list, and get them paid off as fast as you can.

– Dave

• Dave Ramsey has written four New York Times best-selling books: “Financial Peace,” “More Than Enough,” “The Total Money Makeover” and “EntreLeadership.” Follow Dave on Twitter at @daveramsey and on the web at daveramsey.com.

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