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Are 401(k) and 529 Plans a Good Idea When You’re In Debt?

Note:  This is a post from Joan Otto, Man Vs. Debt community manager. Read more about Joan.

As part of our quest to come up with $7,100 for the IRS before April 15, my husband and I decided to cash out a 529 account we’d set up for our daughter’s education expenses. We pulled $2,500 out of that last week.

If you’re not familiar, 529 plans are kind of like 401(k) plans for education expenses. So, much like if we’d cashed out a 401(k) account, this $2,500 will be subject to taxes now that we withdrew the money.

I’ve mentioned before that 401(k)s, 529s and other plans with numbers instead of names aren’t my family’s preference for savings or investments. But why would I take a tax hit to help pay for the taxes?

Well, I’m actually not opposed to investing. I’m certainly not opposed to saving for future expenses. But there are four main reasons why managed savings vehicles like these aren’t right for us, and each of those raises a question I want to challenge you to answer about your own savings plan.

1. I like my money in my hands.

One thing I’m opposed to is having money tied up in inaccessible ways when I have a need for it in the short term.

We fully plan to be able to help our daughter, Sarah, with any higher-education costs she might have.  In order to do that best, though, we need to be debt-free.

$2,500, in the scheme of Sarah’s potential college or trade-school costs, isn’t much. But it’s a third of the amount we need to avoid taking on debt to pay the IRS. In this case, the money in my hands has more long-term benefit, especially when it’s a (relatively) low dollar figure.

At the financial stage we’re in, liquid assets are key. We have an emergency fund in a savings account linked to our checking account, and that’s great – because should we need the money, we can get it quickly.

When we’re debt-free, our emergency fund will likely get much larger. Our “savings” will become separate from it in many ways. Even so, we’ll want to keep a significant amount of money available to us without penalty. We like having our money in our hands.  The security of this is worth the potential “loss” of some interest or investment return.

That’s why we were so glad to cash out the 529 plan money. It was a way to get that money working for us in the way that makes the most sense now.

Ask yourself this:   Of the money you have in savings – whether for a planned event, such as education or retirement, or for an emergency – are you comfortable with the amount you have easy access to. If not, what can you do to bring that amount more in line with your goals?

2. Even a good investment is costing us.

Right now, I have $29,316.52 in my 401(k) account, and Chris has $15,000.42 in his. That’s more than $44,300 that we have in savings. But we can’t get to it – unless I quit my part-time job or he quits his full-time job, there is no way for us to touch that money. Even if we quit, we’d pay a hefty penalty to get access to that $44,000-and-some.

If I had it to do over again, I would never have opened them. Again, I’m not against retirement savings. I’m not even against INVESTING as a method of retirement savings.

But right now, I have $44,000 earning an average 8% annual rate of return, and about $59,000 in consumer debt costing me an average of 14% annually in interest.

You read that right. I’ve got a pretty good set of investments – but I’m not increasing my bottom line with them, because they’re outpaced by the debt interest we’re paying.

At this point, I can’t do much “about” this except complain. I’ve made my choices and I have to put up with them, so I try to keep even that to a minimum. However, I’m very glad we decided two years ago to stop contributing to these plans. While the money that’s there is there, I’m not throwing MORE money into an 8% return to the detriment of paying off the 14%-ish debt. (We have no company match, but I would agree with Dave Ramsey on this – I wouldn’t contribute right now even if we had a match. You don’t invest until the debt’s gone – period – in my opinion.)

Ask yourself this:   Are any investment contributions you’re currently making offsetting any interest you’re currently paying? Even if you plan to contribute again in the future, should you decrease or stop your contributions for now?

3. I like focusing on one thing at a time.

I am whatever the opposite of ADD is. My personality is to hyper-focus, to want to do something at the exclusion of everything else. I’ve learned to make that work for me. And that means that if my focus is on paying off my credit-card debt, I cannot take on another money “thing” at the same time.

Our plan is to pay off what started as $90,000 in consumer debt by the end of 2014. Next, we want to save up for and purchase a car in cash. After that, we want to get some work done on our home, and increase our emergency fund and checking-account reserve, and help pay for some of our daughter’s future expenses, and save for our own future needs.

Many people could and would work on these things simultaneously. For me, that’s distracting at best. At worst, it would lead me to get frustrated – because I like to have ONE goal and be making noticeable progress toward it – and if I didn’t feel good about my progress, I’d probably give up. It’s happened before.

My contention is that the dollar figures don’t change; this is a matter of mental motivation. So we’re choosing to let “savings” beyond our current $1,700 emergency fund be a separate task, to be tackled once the consumer debt is gone.

Ask yourself this:  Do you work better tackling one or two key financial areas at once, or slowly addressing several simultaneously? Are your current actions in line with that personality style?  If not, would you be better served paring down – or expanding your focus – and how can you take action to do so?

4. We plan to remain debt-free for life.

This is what makes the one-thing-at-a-time plan possible. Right now, we pay $2,500 or more a month toward our consumer debt. When that’s paid off, what happens?

  • Putting $2,500 in savings for 1 month gets us right back to where we started, with the $2,500 we cashed out from the 529 plan.
  • Putting $2,500 in savings for 8 months gives us enough to pay cash for the type of car we’re looking for (easily).
  • Putting $2,500 in savings 10 months gives us the ability to make a wonderful gift to our daughter as she begins her adult life.
  • Putting $2,500 extra against our mortgage each month gives us a chance to take 21 years off the life of that loan, which would make us mortgage-free less than 10 years from now.

Add those up. In less than two years after we become consumer debt free, we have the ability to accomplish more financially than a lot of people will in their lifetimes. And in less than 10 years, if we want, we have the ability to be in the 1/3 of Americans who own their home free and clear. That will drastically change the amount of money Chris and I need to “retire” – which gives us so many more options beyond a traditional IRA or 401(k).

But all of that is contingent on TAKING ON NO NEW DEBT. And since we won’t be doing that, we can save in some BIG ways. That’s our “investment” right now – we’re invested in the idea of being and staying debt-free.

Ask yourself this:  If you’re not yet debt-free, do you have a clear vision of what you’ll do with the money you WERE paying when you are? If you’re already debt-free, are the things you’re doing with your money in line with your long-term goals?

I don’t expect that this system works for everyone. I can’t say often enough that personal finance is personal – it’s about finding what gets you in the place you most want to be.

I also don’t expect that we’ll stay investment-free forever. When we have a significant amount of financial freedom, we will likely use smart investments to help grow the money that we’re not using for other goals.

But I’m curious if you’ve examined your own investments or savings vehicles in detail. My fear is that most people contribute to their company 401(k) “because that’s what you’re supposed to do.”

Be willing to think differently. 

And please, share your savings or investment system in the comments!

Category: Bank

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