When I receive a question about cashing out the 401k to pay off debt, my short answer is generally no. The longer answer is still no as a general rule, but it may be a consideration in some very limited circumstances.
Here’s the rationale behind not cashing out the 401k. Sure, it may be tempting to take that big chunk of that savings and throw all at the debts, but the downsides of that choice usually will severely outweigh the benefits.
When you cash out a 401k, or another retirement account, early, the IRS levies a 10% penalty against you. Non-Roth dollars are taxed at your highest federal marginal rate for that year. If you take out $25,000 from your 401k, the penalty automatically takes $2,500 from that withdrawal before your tax rate is even applied.
For traditional dollars, if you are in the 22% tax bracket, that also takes away 22% of your withdrawal. But wait! That withdrawal is counted as gross income for the year, so it could even bump you up to a higher tax bracket, further increasing your tax liability for the year.
You may also owe state income taxes on that withdrawal. In Virginia, the top marginal rate is 5.75%, which is not terribly high. However, other states have top marginal rates of 9%, 10%, or even all the way up to 13.3% in California!
Think of how all of those taxes chip away at your life savings as soon as you cash out your 401k. Is it worth losing nearly half of that money upfront, as well as the tax-sheltered long-term growth in the account? In almost all cases, the answer is no.
As a coach, I have found that there are two exceptions to this otherwise rigid rule: avoiding a bankruptcy or a foreclosure.
Both a bankruptcy and a foreclosure are extremely heavy burdens to bear. A Chapter 7 bankruptcy will clear one’s debts, but secured assets in the bankruptcy are repossessed. One may reaffirm the debts, but the debtor still owes the creditors for those debts not liquidated in the Chapter 7.
A Chapter 13 is a three-to-five year payment plan whereby the debtor gives a large portion of financial control to the Chapter 13 trustee for their region. It is difficult to do anything during this time, even a debt snowball, so I strongly recommend avoiding a bankruptcy in nearly all circumstances.
A foreclosure is also a devastating experience. Imagine losing the home you’ve lived in for years, made renovations on, worked so hard for that down-payment, and in which you dreamed about raising your family. The foreclosure sweeps that away, wrecks your credit, and uproots emotional stability in your family’s life.
Normally, I do not suggest cashing out a 401k to pay off debts. However, if your current track is either a bankruptcy, or a foreclosure, or even both, then it may be something to seriously consider only to avoid either of those things from happening. The cost of the early cash-out is high, but not as high as a bankruptcy or foreclosure.
These are largely the only two circumstances under which I will even entertain the option, especially a Chapter 13 bankruptcy. I’ve had multiple people come to me looking for help, but were unable to work with me at that time because the trustee would not allow them to work my fee into their plan.
These folks had to largely continue on their own or through Financial Peace University (if even that was allowed), though they would have worked out of the bankruptcy much more quickly with my guidance.
That’s a fate I don’t want for anyone. If it requires you to cash out your 401k, that’s something we can discuss to see if it really is the better of two bad options.
If you need help in making this decision, reach out to me so we can talk about the best path moving forward. In our conversation, I will handle your concerns with the utmost care and sensitivity to what you’re dealing with.