Maybe you have lost a job, making it difficult to stay current on mortgage payments. Maybe an illness or prolonged sickness has created medical bills you can’t possibly pay. With these financial pressures, you find yourself using credit cards more and more often just to make ends meet. Given the difficult economic times in which we live, many couples and individuals have found themselves facing insurmountable debt through circumstances beyond their control. As a result, many Americans have chosen to cash in their 401(k) in order to pay down debt owed on credit cards and medical bills. Doing so, however, could end up costing you thousands – if not hundreds of thousands – of dollars in the end.
The Cost of Cashing in Your 401(k)
If you’re considering cashing in your 401(k) to avoid bankruptcy, it’s essential to stop and ask yourself what the real costs of doing so will be. First, there are tax penalties that must be assessed. For example, if you are under the age of 60, you must pay 10% in taxes on what the total value of the distribution will be. Secondly, when you cash in your 401(k), it will be treated like income for tax purposes. Consequently, you’ll pay additional taxes on your 401(k) as part of your income taxes.
In general, assuming you are under the age of 60 and don’t have any special extenuating circumstances that might reduce the taxes owed on your 401(k), you can expect to pay up to as much as a third of its total value in tax penalties. This means if you have $100,000 in your 401(k) that you withdraw to pay off your bills and stay current on your mortgage, you could only see anywhere from $60,000 to $70,000 of its total value.
Additionally, had you not cashed in your 401(k), you would have seen additional earnings on it as its value compounded over time. Now, however, these earnings must be considered “lost earnings” and added to the cost of cashing in your 401(k). As a result, the actual cost of cashing in your 401(k) could reach into the hundreds of thousands if lost earnings are taken into account over the life of your 401(k) account.
401(k)s and Chapter 7 or Chapter 13 Bankruptcy
First, it’s important to realize that if you file for Chapter 7 or Chapter 13 bankruptcy, your 401(k) is protected. The bankruptcy court can’t seize your 401(k) account and liquidate it to pay off your debts. Secondly, once you file for Chapter 7 or Chapter 13 bankruptcy, an automatic stay goes into effect, requiring creditors and your bank to stop all debt collection or foreclosure actions against you. Third, when you file for bankruptcy and successfully complete the terms of your Chapter 7 or Chapter 13 filing, debt on credit cards, medical bills, certain kinds of loans, and other forms of unsecured debt will be wiped out. Consequently, filing for bankruptcy can save you tens of thousands of dollars while helping you get back on your financial feet.