Don't Touch That 401K!

Calm sea with blue beach chairs on the sand visual concept for 401K.

You want to be a good person and pay your debts. The idea of filing for bankruptcy may scare you or make you feel ashamed – like you’re not living up to your obligations. If so, you may be tempted to withdraw funds from your 401k account or other retirement assets to pay off your debts. But this is almost always economically unsound. Don’t touch that 401k without talking to a bankruptcy attorney first!

Should You Use Your 401k Retirement Assets to Pay Off Debts?

Don't tap your 401K or retirement savings as a last resort to pay debt. Particularly credit card debt. All too often, clients wait to hire a bankruptcy attorney for help after draining their retirement assets to pay credit card debt or medical bills. Bankruptcy is almost always a better alternative.

Banks, credit companies, and other lenders are equipped to handle unpaid debts. Tax write-offs for bad debts are part of their companies’ financial plans. They knew exactly what they were doing, and the statistical probability of default, when they gave you the money in the first place.

You, on the other hand, may not have known exactly what you were getting into when you signed up for that credit card or took on that medical debt. You may not have realized:

  • How high the balance or interest rate would be on those medical bills.
  • How difficult high-interest credit is to re-pay.
  • How the balances never seem to go down.
  • How unpaid debts can strap your family's finances out of proportion to the value received.

When the bills come due and the creditors start calling, you may naturally look to your retirement savings as a last resort to pay your debts. However, filing for bankruptcy is almost always a better alternative with less negative impact on you and your family for the indefinite future. After all, no one can work forever. You will eventually need the money you have saved for retirement. In addition, many retirement accounts have legal limits on when and how money can be withdrawn, which could put you at an even greater financial disadvantage.

What is the Penalty for Early 401k Withdrawal?

Regardless of whether you are filing for bankruptcy, tapping retirement funds early to pay off debts is a bad choice, financially speaking. Making an early withdrawal from a 401(k) employer-contributed retirement plan, 403(b) plan for state employees, or certain IRA accounts can lead to heavy penalties and tax consequences. There are two main financial effects of withdrawing funds from age-restricted retirement accounts:

  • Income tax on pre-tax contributions to retirement accounts
  • Age-restricted penalty fees

The first applies any time you withdraw funds from a pre-tax retirement account, even during retirement. Since the money was originally excluded from your income when you made the initial deposit, you instead have to pay tax on it when the money is withdrawn from the retirement account.

However, early 401k withdrawal is also subject to a 10% penalty fee for any withdrawal prior to age 59 ½. There are certain limited hardship exceptions that allow withdraws in the case of:

  • Medical expenses exceeding 7.5% of your gross income
  • Paying court-ordered child or spousal support
  • Preventing eviction or foreclosure
  • Paying funeral costs for an immediate family member

Still, withdrawing 401k funds to pay unsecured debt like credit cards or utility bills will almost certainly mean taking a 10% penalty on top of the tax consequences. In addition, the money you withdraw today won’t be able to be invested, which means your retirement savings will take an even bigger hit.

Will You Lose Your 401k During Bankruptcy?

It is almost never worth receiving that penalty to pay off unsecured debt rather than filing for bankruptcy. Unsecured debt is disfavored by the bankruptcy court and is easily discharged. In a Chapter 13 bankruptcy payment plan, these unsecured debts are often the last to receive a share of your income – after your mortgage, car payment, and other secured debts. That means unsecured creditors get the smallest share of your payments.

If you are filing a Chapter 7 bankruptcy, you may not realize that retirement assets are protected from forfeiture. This has been undisputed since the mid-1990's. If an account is ERISA-qualified (including 401Ks, 403Bs, pensions and many others) its exempt status is rarely if ever questioned. That means your retirement accounts will not be liquidated to pay off your creditors. If you have already exhausted most of your other disposable assets, you may be able to discharge your debts without losing much of what you own.

Talk to a Bankruptcy Attorney Before You Touch Your 401K

Like most people, you want to pay your debts. But before you tap into your retirement, please consider that bankruptcy is a powerful corrective tool. It doesn’t have to be scary or shameful. In fact, in many cases it makes good financial sense.

If you are considering an early withdrawal from your 401k to pay off debts, you should talk to a bankruptcy attorney first. Depending on the nature of your debts, your financial situation, and your assets, a bankruptcy may be able to protect your assets and give you a comfortable retirement, along with relief from creditors and collections cases.

At Lawrence & Jurkiewicz, we can help you understand the long-term consequences of taking early 401k withdrawals to pay off debts, and help you consider other alternatives. We will meet with you to review your financial circumstances and help you decide whether to file for bankruptcy, withdraw retirement assets, or negotiate with your creditors. We want to help you make the right decisions for you and your family. Please call (860) 264-1551 or contact us for a consultation.

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