Dear Liz: I am wondering about withdrawing my 401(k) early to pay off debt. My husband is the primary breadwinner of our household and has just been laid off.
At the beginning of 2008 we had over $25,000 in debt, which we reduced to $19,000 over the last year. I fear that without his income we will be facing bankruptcy. We have considered refinancing our home, but our second mortgage has a prepayment penalty until September.
I realize that cashing out my retirement is possibly the worst option, but I am running out of ideas. If you have any advice I would appreciate it.
Answer: In most cases, you’ll want to conserve cash after a layoff. That means paying just the minimums on your debts while you look for ways to cut expenses and find cash (by selling stuff or taking part-time jobs, for example). Once you’ve got your expenses comfortably below your income you can begin to repay your debts out of that income.
Withdrawing money prematurely from a 401(k) is usually a bad idea, but that’s especially true if bankruptcy is a possibility, since retirement accounts are off-limits to creditors. In other words, you’d be taking money that would otherwise be protected and using it to pay debts that could be erased in a bankruptcy filing.
You would also be incurring unnecessary taxes and penalties that can eat up 25% to 50% of your withdrawal, and you’d lose all the future tax-deferred returns that money could have earned.
If your debt is primarily on credit cards, consider contacting a legitimate credit counselor affiliated with the National Foundation for Credit Counseling at www.nfcc.org to see whether you could benefit from a debt management plan. Also, make an appointment with an experienced bankruptcy attorney so you and your husband can explore other options.
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