Ask Liz Weston

Dear Liz: I have almost $250,000 in my retirement accounts. I also have almost $50,000 in credit card debt. Should I take $50,000 from my 401(k) to pay off the debt?

Answer: No, no, no.

In case that wasn’t clear: No.

Of all the dumb financial moves you can make, raiding retirement funds to pay off credit card debt ranks near the top. You’ll pay penalties and taxes that typically equal one-quarter to one-half of any withdrawal, plus you lose the future tax-deferred returns that money could make. If you’re 30 years from retirement, that $50,000 withdrawal would cost you $500,000 in lost retirement income, assuming an 8% average annual return.

The fact that you have that much debt puts you at high risk of bankruptcy. In bankruptcy, your unsecured debt can be wiped out or reduced, while your retirement funds would be protected from creditors.

If you can’t figure a way to pay off your debt without raiding your retirement, you need to make two appointments: one with a legitimate credit counselor (visit the National Foundation for Credit Counseling at www.nfcc.org) and another with a bankruptcy attorney.

Dear Liz: It looks as if I will have to file for personal bankruptcy because of a business failure. (I guaranteed the debts personally, and there are two I know I can never repay.)

I could possibly keep the business open a few more months if I stopped paying a few of the other creditors, thus keeping my workers employed a little longer.

I know my FICO score will drop when I file, but will it drop more if I stop paying bills before I file, or is the FICO drop the same no matter what?

Answer: The end result will be about the same.

If you stop paying some bills, those skipped payments will lower your score substantially. Once you file for bankruptcy, your score will drop some more.

But the effect of bankruptcy on your scores is so profound that you’ll end up in about the same place as you’d be if you had filed without ever having missed a payment. Either way, your scores will be in the basement.

If you believe bankruptcy is inevitable, consult a bankruptcy attorney now. It’s easy to make mistakes that could endanger your bankruptcy filing.

You don’t want to wind up with shattered scores but still owing these impossible-to-pay debts.

Dear Liz: I just received rate increases on two of my credit cards that are together going to send me into bankruptcy. I didn’t think it could happen to someone who has perfect credit, has not maxed out the card and has been steadily reducing the balance and not charging anything, but obviously it can. I had every intention of repaying my debt, but these arbitrary increases — which will add $600 a month to my payments — have made it impossible.

I feel foolish for having this debt at all, but I lost my mortgage business and my husband is in construction. We have had a really bad four years. If they had just allowed me to continue making the payments per our original agreement, I would have been able to continue reducing the balance and they would get their money. This way, they won’t receive any money at all. How does this make sense?

Answer: Credit card issuers know full well that their latest rate increases will send some of their borrowers to Bankruptcy Court. What they’re hoping is that they’ll get enough interest from those who can still pay to offset the losses from those that can’t.

All may not be lost. Many issuers who have instituted these rate hikes offer an “opt out” provision that would allow you to keep your original rate if you agree to close the account. You should contact your issuers to see if this option is available. Closing accounts can ding your credit scores but will cause far less damage than a bankruptcy.

Be realistic about your financial situation, however. The amount of the proposed payment increase indicates you’re carrying substantial debt on those cards. Unless your financial situation improves dramatically, it’s probably only a matter of time until a misstep or another change in terms causes you to fall behind.

If that’s the case, bankruptcy may be a better option than continuing to struggle with debt you’ll never repay.

Dear Liz: My question is whether I should file for bankruptcy or try to settle my debts.

I owe about $50,000 on credit cards, $120,000 in student loans and $701,000 on my home. I have stopped paying on my credit card debt because my issuers increased their rates and were unwilling to work with me, so I am unable to pay even the minimums they now require. My mortgage is being modified, although it has been four months since the process started and I have received a notice of default, which is the first step in the foreclosure process.

I am unsure what to do, but I do know I don’t have anywhere else to go. I have to provide a safe haven for my children and disabled parents. What’s your advice?

Answer: You need to talk to a bankruptcy attorney, pronto.

That doesn’t mean filing for bankruptcy will necessarily be the right choice. You won’t be able to eliminate your student loan debt. If your income is too high, you’ll be put on a payment plan instead of being able to erase the credit card debt.

But it may well be the best of bad options. Debt settlement is typically available only for credit card debt, and you would need a sizable lump sum of cash to persuade your issuers to negotiate.

And even if you get a mortgage modification, your housing problems may not be solved. Borrowers too often agree to a modification of a debt that never has been, and never will be, affordable. That’s why so many mortgage modifications have resulted in default and foreclosure.

What you need is an educated third party to look at your finances and explain your options to you.

Dear Liz: I’m a 65-year-old retiree with a large part of my retirement savings ($800,000) in two past employer 401(k)s. I would like to roll at least one of these to an IRA but am concerned about protecting the savings from legal claims should a catastrophic event occur. Can the money be protected?

Answer: The easiest solution is to leave the money where it is. Workplace retirement plans such as 401(k)s offer more protection against creditors’ claims than IRAs if you are sued or file for bankruptcy.

That said, all traditional and Roth IRAs are protected to $1 million in a bankruptcy filing, and rollovers from employer plans into an IRA have unlimited protection in that situation.

If you’re concerned that your savings would grow beyond that protection or that you might face creditors’ claims outside a bankruptcy, you could reduce your risk by ensuring that you have adequate liability insurance.

Of course, your best bet if you’re concerned about liability is to discuss your situation with an experienced attorney.

Dear Liz: The 401(k) plan at work has been terminated. We have $51,000 in credit card debt and $45,000 in the 401(k) account. Should we pay the 20% withholding tax and early penalty to get out of debt?

Answer: Of course not. Using retirement money to pay off debt is stupid on a number of levels.

The 20% that’s withheld when you prematurely withdraw money from a 401(k) often isn’t enough to cover the actual tax bill. You’ll pay taxes at your regular federal and state income tax rates on the money, plus penalties. (The federal penalty is 10%, plus whatever penalty your state adds.) Even if you’re in the 15% tax bracket, you’ll have to pay taxes equal to more than a third of the money you withdraw. At higher tax brackets, you could lose half or more of the money you take out.

Once the money is withdrawn, you can’t put it back. That means you lose all the future tax-deferred gains the money could have earned. Assuming an average 8% annual return over 30 years — and the stock market has achieved that, even counting in the years of the Great Depression — you’ll wind up losing $10,000 or more in retirement money for every $1,000 you withdraw now.

Furthermore, money in a retirement account is protected from creditors should you wind up in bankruptcy. Before you use protected money to pay off a debt that could be erased in a bankruptcy filing, you should talk to an experienced bankruptcy attorney.

Dear Liz: I filed bankruptcy in 2005, just before the laws changed. My husband-to-be is hesitant about marriage since he believes my bankruptcy will affect his business and his shining credit score. I have been telling him my past financial tribulations do not reflect on his credit score. Where can I find this in writing to prove what I say is true?

Answer: There’s no such thing as a joint credit report or a joint credit score. Each individual has his or her own, and they aren’t combined when you marry.

Your troubled history could affect him going forward, however, if you two decide to get a loan together, such as a mortgage. Your lower credit scores could make it more difficult to get approved and probably would trigger a higher interest rate than he’d have to pay otherwise.

His reluctance to marry you may have deeper roots, of course. Since your finances have foundered before, he may worry that they could again, and he would be on the hook for bailing you out.

You may need to reassure him that you’ve mended your ways.

That means living within your means with no credit card debt, a substantial pad of savings and adequate insurance. If you’re not there yet, you may at least need to prove to him that you’re well on your way.

Otherwise, his reluctance to marry wouldn’t be cold feet. It would just be prudent caution.

Dear Liz: My husband and I both lost our career jobs over the last two years. Since that time we have done everything to try to stay afloat, including borrowing more money on our credit cards, borrowing from our home equity credit line and liquidating our retirement accounts.

We have continued to interview while working $12-an-hour jobs, but now face not being able to borrow any more money. With the current government aid going to those needing mortgage help, should we stop paying on our first and second mortgage or stop paying on our other bills? We could probably make it if we could refinance, but without “real jobs” and enough income to cover our debts today, I would not think we would qualify.

Answer: You’re probably right. The days of people getting mortgages without being able to document sufficient income are over.

You understandably hoped for better days, but by refusing to drop your expenses below your income you’ve essentially squandered your retirement and borrowed yourself into a corner.

You still may have some options. The Homeowner Affordability and Stability Plan announced by President Obama does not require that you default on your mortgage before you can get help. You should contact a housing counselor approved by the U.S. Department of Housing and Urban Development to review your options. You can find referrals to HUD-approved counselors from a link on the department’s home page, www.hud.gov.

But you also should talk to a bankruptcy attorney. Having to choose between paying your mortgages and paying your other bills indicates a debt load that may be too high even if you do get mortgage relief.

Actually, you should have consulted a bankruptcy attorney before you touched your retirement accounts or home equity. Those assets could have been protected from creditors and you at least could have emerged from this crisis with something for your future.

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.

Dear Liz: Do you recommend debt consolidation or debt settlement for a Californian who brings home only about $1,200 a month and owes $48,000 on credit cards? I’m over 45, have no assets and have lost my job twice in my lifetime.

In the past, I have always paid my bills as agreed, on time. Currently three of my five cards are on “credit protection,” which means I don’t have to make payments on them until next year. Right now, I am barely making payments on my two other cards and living expenses, plus I’m beginning to use the cards for everyday expenses such as gasoline and food, which frightens me.

The majority of the accumulated debt was for living expenses and paying the rent (by using bank-card checks) since 1996, the first time a managerial job ended. Other credit debt was from auto repair and maintenance for the older cars I had owned over time. About $4,000 was personal spending done in the last four years.

I have always somehow had faith (maybe wishful thinking) that I would be able to pay it all down substantially — even at times working two jobs seven days a week, having other responsible positions, and at times being able to pay larger monthly amounts on some cards. But now, at my age, the realities of life are really hitting me hard and I know that I am just way over my head. Come June 2007, I will need to change my entire financial life, because that’s when the credit protection expires on those other cards. What are my choices?

Answer: It’s human nature to hope that our circumstances will improve. But when it comes to debt, wishful thinking often leads to digging a hole that may be too big to get out of on your own.

The credit protection plan that’s allowing you to skip payments probably isn’t doing anything about your interest charges, which are still piling up. These expensive contracts are often touted as a way for people to protect their credit while they’re unemployed or disabled, but they often result in balances ballooning over time.

A good way to start is by talking to a legitimate credit counselor, preferably one affiliated with the National Foundation for Credit Counseling (www.nfcc.org). The counselor will take a look at your income and debt to see if you qualify for a debt repayment plan, which would allow you to repay what you owe while reducing or eliminating finance charges.

Given how much you owe, however, and how little you earn, a credit counselor may not be able to help you. If that’s the case, then bankruptcy may be the best of bad options. Filing for Chapter 7 liquidation costs more than it did before bankruptcy overhaul laws kicked in Oct. 17, but your low income means you won’t be prevented from doing so by a new income “means test.”

Debt settlement is a possibility if you want to try to pay at least some of your debt, but understand that settlements, like bankruptcy, can be devastating to your credit.

Also, unscrupulous collection agencies have been known to try to pursue borrowers for the unpaid portion of a supposedly settled debt, and the amount that’s forgiven may be reported to the Internal Revenue Service as taxable income to you. If you choose this path, get the help of an attorney experienced in such negotiations.