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Once the money is withdrawn, you can’t put it back.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 â€” 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.
Q: We are in quite a tight spot financially. We have extensive medical bills because of poor health insurance and high deductibles, along with past-due credit card bills, past-due taxes and a judgment that a creditor recently won against me in court. This creditor just placed a levy on our checking account, which of course is now overdrawn. There is no possible way for us to get caught up. We have four children and no assets. Is filing for bankruptcy protection an option?
A: Bankruptcy might be the best of bad options, but you’ll want to make up your mind fairly soon. The bankruptcy overhaul legislation that Congress passed this year takes effect Oct. 17, and some people will find it much harder to have their debts erased.
Your situation is not at all unusual. A recent Harvard University study found that half of all consumer bankruptcies were triggered by medical problems. Interestingly enough, about three-quarters of the people who filed medical-related bankruptcies had insurance when they became ill or disabled. They often lost their insurance after losing a job or, like you, had inadequate coverage and high deductibles that left them exposed to catastrophic bills.
Another way you’re in the mainstream of bankruptcy filers: You have kids. Harvard bankruptcy researcher Elizabeth Warren, coauthor of “The Two-Income Trap: Why Middle-Class Mothers and Fathers Are Going Broke,” found that having children is one of the leading predictors that a household will file for bankruptcy.
Ideally, everyone would have adequate insurance and savings to confront the inevitable setbacks life offers. When that’s not the case â€” and it often isn’t â€” you should look for alternatives, such as working a second job, trimming your budget and selling assets to pay your debts. If that won’t cover what you owe, a bankruptcy filing might be a better course than struggling forever with impossible debts.
An experienced bankruptcy attorney can apprise you of your options, and many offer free consultations. Good luck.
Dear Liz: After 25 years as a homemaker and mother, I was divorced. I had to find work, create an income and begin life over. I am now 65 and in very good health, with loving children and a small business. But I am in debt and have no savings for the future. I awake each day to find I have more debt. It’s not healthy debt that I could handle, but over-the-top debt that I will never be able to repay. I acknowledge that I have a Cinderella princess mentality, thinking a prince will come along to rescue me, and that I’ve lived an upper-middle-class lifestyle that’s beyond my means. I have done my emotional work in overcoming the idea that I’m a victim and thus not responsible for my situation. But I still can’t act. My children do not know of my immediate disaster nor do my clients. I feel frozen and unable to reconcile myself to the inevitable, disrupting their lives and their image of me. What now?
Answer: You act.
Emotional work is all fine and good, but it’s pretty useless if you’re not using your insights to change the way you behave.
And, as you intimated, you’re behaving like a child. Children can believe in fairy tales and last-minute rescues, but grown-ups take charge of their own lives.
This won’t be fun. If you truly can’t repay this debt, you may end up filing bankruptcy or negotiating settlements with your creditors. You may have to move and live a more basic lifestyle.
But every day you delay, you’re adding to the pile of debt you owe. And you already have two things–good health and loving kids–that many rich people would trade their fortunes to achieve. Keep that in mind in the coming difficult days.