When you are drowning in credit card debt, medical bills, loans, and other debts, you may be looking for any way out. One option you might consider is cashing out your retirement account, or your 401(k) to pay off your debts.
We get the logic – it’s your own money, so doesn’t it make sense to use it to get out of debt and rebuild your retirement fund? In short, no, this is not recommended.
Our expert bankruptcy attorneys discuss why you shouldn’t cash out your retirement account, and other options you can pursue instead.
Why You Shouldn’t Withdraw From Your Retirement Fund to Pay Off Debt
When you withdraw money from your 401(k) or IRA, you will face large early withdrawal penalties and will be taxed on any cash you take out. Sure, you will get rid of your debt and eliminate your monthly payments, but you will need to pay penalties and taxes. Plus, you are wiping out your retirement fund and will need to make up those funds as well.
Retirement accounts like a 401(k), IRA, or Roth IRA are meant to be accessed when you retire. Because of that, they are heavily regulated. If you withdraw money out of one of your retirement accounts before you are 59.5 years old, you will face financial penalties. The exception is if you roll the money into another retirement account. So if you start a new job that uses another retirement account, you can withdraw that money and deposit it into your new retirement account within 60 days and avoid financial penalties.
If you just withdraw the money or forget to roll it over within 60 days, you will face the following penalties:
- 401(k): Taking money out of your 401(k) will result in a 10 percent penalty and 20 percent in taxes. Plus, whatever you withdraw will count towards your taxable income.
- Traditional IRA: Like with a 401(k), withdrawing money early from your IRA will result in a 10 percent penalty. You will also need to pay income taxes on the amount you took out.
- Roth IRA: The Roth IRA is different from the other two. Because this retirement fund uses after-tax dollars and increases tax-free, you can pull out any contributions at any age without penalties or additional taxes. However, before you get too excited, there’s a catch. This applies to contributions – not earnings. To withdraw money earned from compound interest, you must be 59.5 years old and your account must be at least five years old to avoid a 10 percent early withdrawal fee.
Exceptions to Retirement Fund Withdrawal Penalties
Like with anything, there are exceptions to the rules when it comes to taking money out of your 401(k) or IRA early. You can avoid the 10 percent early withdrawal penalty by using the money for the following situations:
- You need to pay off medical expenses if they total more than 10 percent of your gross income.
- You had a child or adopted a child.
- You are called into active military duty.
- You are paying off an IRS tax levy.
- You are permanently disabled.
- You die, and your beneficiaries need to access your retirement accounts.
In a 401(k) account, you can also withdraw money without penalty if you quit your job when you are 55 years old or older, or if you’re getting divorced.
In IRA accounts, you can avoid penalties if you withdraw money to pay for approved college expenses, or if you are using the funds to buy a first home.
It’s essential to note that while you can avoid the 10 percent penalty under these scenarios, you will still be taxed on the money you withdraw.
NOTE: The above is general advice on how the taxes and penalties work. The above is not to be construed as legal or tax advice.
Why You Should Avoid 401(k) Loans
A popular option many people use when they need money quickly to pay off bills or fund projects is to take out a loan from their 401(k). We hear a lot of people justify it by saying they are just borrowing money from themselves. Well, yes, you are, but you are also paying interest on the loan.
And there is a lot of risk to consider. If you quit or lose your job, you must repay the loan within 60 days or you will be penalized 10 percent, plus pay taxes on it.
Retirement is Almost Fully Protected in Bankruptcy Proceedings
In general, you can file for bankruptcy, eliminate your debt, and still keep your retirement accounts. Although there is an upper limit to the amount that can be protected, in my 16 years of practice, this has never been an issue. You need the retirement for your retirement; not to pay your debts. This also decimates future returns on your investments because your retirement principle is lower. In short, before you pull money out of retirement to pay a debt, talk to a bankruptcy attorney to fully understand all of your debt relief options.
Other Options to Get Rid of Debt
Instead of dipping into your retirement funds, there are other options to get out of debt. For one, you can seek a debt relief program. A debt relief attorney can help you determine if you qualify and guide you through the process. This will usually result in reducing your overall debt.
Another option is bankruptcy. A bankruptcy attorney can help you determine if this is the right step for you, if you qualify for Chapter 7 or Chapter 13 bankruptcy, and explain the pros and cons of these. In both options, you will be able to get rid of your debt by the end of the process.
Let Us Help You
If you are facing large amounts of debt and are considering withdrawing money from your retirement accounts, get expert advice. Let our lawyers at The Law Offices of Alexzander C.J. Adams, P.C. help. We will walk you through your options so you can make an informed decision. We work for you, the people, and not institutions. Contact us for a free case evaluation, or no-obligation consultation. We are dedicated to helping you overcome this small bump in the road and assisting you to get on with your life.