I can’t tell you how many times I have heard this story from a prospective client:
I ask: “Do you have any retirement accounts or 401(k)?”
Response: “No, we liquidated those to stay afloat.”
I feel sad when I hear that because I know that if he had the courage to visit the office 6 months ago or a year ago when his finances started going south, he would be out of debt and still have that money. Too many debtors are sacrificing their future and treating their 401(k) or IRA as a piggy bank instead of a retirement fund.
Often times we are talking about substantial sums of money, $40,000, $70,000, $120,000, etc. Keep in mind what the person is saying, it is not just “staying afloat”,she is using the money to pay credit card bills that have become too much, or pay on an adjustable rate mortgage that just increased to keep an underwater house. Instead of focusing on the real problem, dealing with high expense; the debtor chose to supplement income by liquidating or borrowing from a retirement account; which is a colossal mistake.
I have 3 rules for dealing with a personal debt crisis
1. Never turn unsecured debt into secured debt;
2. Don’t rule out any options; and
3. Never borrow or withdraw from a retirement account to pay debt (except a non-dischargeable tax debt).
ERISA qualified retirement accounts (e.g. 401(k), 403(b), IRA, etc) are protected in bankruptcy, you don’t lose that money when you file bankruptcy. As such, withdrawing money from a retirement account to try to avoid bankruptcy is a gigantic waste of money; not just that you lose 30-40% of the value in taxes and penalties, but you lose the future growth of that money. So the true cost of liquidating $50,000 is not the $15,000 to $20,000 you will lose right off the bat in tax and penalties (although that should be enough of a reason not to do it), you also lose the approximately $77,287 of anticipated growth of those funds over the next 10 years. So the true cost of withdrawing those funds is about $130,000. Finally, withdrawing the money rarely solves the problem. The person is not—paying off—debt with the money, they are using it to stop the bleeding of spiraling expenses; they are just delaying the inevitable bankruptcy.
The mere “idea” of withdrawing funds from a retirement account should be a red flag; the idea is symptom of a greater financial problem. It is like chest pain that precedes a heart attack. Instead of lying down and taking an aspirin, the person needs to get to the hospital ASAP. You should treat the idea of withdrawing from a retirement account the same way; the minute you think that you should withdraw from your retirement, stop! That idea is a wake-up call; stop and get yourself to the financial hospital; visit a bankruptcy attorney and cure your financial problems.
