Is Using Your 401(k) to Pay Off Debts a Good Idea?

Don't risk your future —ind a better way to deal with debt!

Image Source: Flickr user Jason Tester Guerrilla Futures 

If you’re drowning in debt and living paycheck to paycheck, you’re likely thinking short-tert about just keeping your head above water financially. Many consumers dealing with these circumstances drain their savings and then may start taking money from their 401(k), but is tapping your retirement account to pay off debt really the way to go?

Today Vs Tomorrow

Dealing with debt collectors is a hassle, and you might do anything to keep them off your back. Expert debt collectors know how to push your buttons and encourage you to max out credit cards, dig into your savings, and sacrifice your future to pay them today. This is dangerous behavior, and you might be pressured into doing something you’ll regret.

Taking cash out of your 401(k) means you’ll have far less for retirement down the road, and borrowing against your 401(k) with the account as collateral means you’re still just as much in debt as you were before. Neither scenario is good. You don’t want to dip into your 401(k) to pay debt, particularly debt that could be dealt with in other ways. 

Tax Implications of Tampering With Your 401(k)

Because money goes into your 401(k) on a pre-tax basis, there are tax consequences when you pull money out. What this means is the retirement funds taken out of your check were not subject to income tax withholding, but if you take money out of the account, then you’ll be hit hard.

First off, there’s a 10% penalty for withdrawing any funds prior to age 59 ½. Second, another 25% will be withheld to cover income taxes. For example, $5000 is worth just $3250 towards your debt after taxes. That’s a hard hit since you’ll lose 35% of the money, plus there’s the time value effect. You’re not just losing that $5k, you’re losing all the interest that $5k could have earned over the long haul.

Better Options For Dealing With Debt

A far better approach to dealing with debt is to consider bankruptcy. North Carolina consumers have the option of either Chapter 7 or Chapter 13 bankruptcy. With Chapter 7, most unsecured debts can be discharged within months. This includes credit cards, medical bills, personal loans, and more.

Chapter 13 allows you to get on a repayment plan to catch up past-due balances on secured debt—like your car loan or mortgage—while also offering some relief on unsecured debts like credit cards and medical bills. You may also be able to strip away a second mortgage using Chapter 13 and lower your principal and interest rate on qualified auto loans.

If You Can’t Save Money, That’s a Problem

How do you know if your finances are so bad that bankruptcy is the way to go? If you’re living paycheck to paycheck, have maxed out your credit cards, are paying bills late, only paying minimums on credit cards, and can’t afford to save, then you need a debt intervention.

You can try to work out a repayment plan with your creditors, but they’re generally inflexible. Chapter 13 or Chapter 7 bankruptcy can help. You can file Chapter 13 bankruptcy no matter your earnings so long as you can afford the court mandated repayment plan.

Don’t assume you won’t qualify for Chapter 7, though, which is a more sweeping form of debt relief. If your debt far outweighs your ability to pay, you may qualify even if you earn a high income. To find out more about your debt-relief options, contact the Law Offices of John T. Orcutt.

Call +1-833-627-0115 now for a free North Carolina bankruptcy consultation at one of our convenient locations in Raleigh, Durham, Fayetteville, Wilson, Greensboro or Wilmington.