Your 401(k) plan or IRA may be one of the few assets that is protected in bankruptcy. Cashing in these funds to stave-off bankruptcy may be short-sighted in two ways: First, you just postpone the inevitable, and second, when it comes, the only non-attachable asset you have is now gone!
With the economic downturn, many people are looking to their IRA or 401(k) plan as a source of emergency income. They want to tap into those funds, oftentimes to pay off debts or maintain their current lifestyle. When I search the "stats" section on this blog, one consistent hit of search terms that comes up is "cash in 401(k) to pay off (debt, credit card, mortgage)"
Don't do it!
Why? Well, as I explained in my "Using your 401(k) to pay off your mortgage" posting, the tax penalties are enormous, not to mention the taxes involved (cashing in a large sum will put you in the highest bracket). So it is not an effective means of paying off your home.
But some folks think, "Well, I'll just take a little out to tide me over, to make the mortgage payments and car payments and support my lifestyle - that way the taxes won't be so bad!"
Don't do it!
Why? Well, if you are facing such a situation - onerous credit card debts, an expensive lifestyle, etc., and you are thinking of "dipping" into your retirement savings, chances are it really means you need to think about cutting back on your lifestyle and possibly doing a workout with your creditors and/or exploring your bankruptcy options.
Your 401(k) and IRA may be protected from creditors in bankruptcy, and thus, if you have to declare bankruptcy, you may lose your home, your car, and some personal possessions (but perhaps not all, consult an attorney for more details). But your retirement savings - the only liquid cash you have - may be protected from creditors.
Thus, when you emerge from bankruptcy, you may have something to your name - savings and a retirement plan. They might take it all, but not that.
On the other hand, if you fritter away your life's savings trying to "hang on" to things, when you run out of 401(k) money, they will come and take away your things and then you will be truly destitute.
Which is a better option?
And yet I know a number of people who have done just that - cashed in their retirement nest eggs to pay off credit cards or other debts, or simply use as money to live on. What will they live on when they retire?
If you are tempted to dip into your retirement money before age 59-1/2, then you should talk to a credit counselor (a real one, not a con-job) and a bankruptcy attorney (ditto) and explore what your options are. The urge to dip into retirement savings may be the miner's canary - a sign that you need to take action NOW, rather than later. Cashing in your retirement plan is a bad move - it just delays and prolongs the inevitable and also makes it that much more painful in the long run.