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Once the money is withdrawn, you can’t put it back.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.