When I receive a question about cashing out a 401k to pay off debt, my short answer is generally no. It entails a lot of unrecoverable loss of long-term growth. We can make more money, but we cannot recover time. Nonetheless, there are some limited circumstances in which cashing out a 401k may be the best option.
But there are some harsh consequences to making this choice. Consider this before contacting HR.
Tax Consequences of Cashing out Your 401k
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. The IRS taxes non-Roth dollars at your marginal tax rate for that year. If you cash out $25,000, the penalty automatically takes $2,500 from that withdrawal before the marginal tax rate kicks in.
For traditional dollars, if you are in the 22% tax bracket, that also takes away 22% of your withdrawal. But wait! That withdrawal counts as gross income for the year. So it could even bump you up to a higher tax bracket, further increasing your tax liability.
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.
Long-Term Consequences
Cashing out 401k funds steals from your future. The basic concept of the 401k is to have tax-advantaged growth that will create a nest egg for retirement. When you take from the nest egg while it is growing, the potential for the future is hampered.
Consider the example of the $25,000 above. The tax consequences are already harsh. But what you lose out on long-term is even harsher because of the power of compound interest.
Let’s say you’re 40 years old when you decide to cash out your 401k early. Let’s also say you plan to fully retire at age 70 and start taking withdrawals at that point. If you invest in mutual funds that average the S&P 500’s rate of return (10%), that will grow significantly over time.
After 30 years, at a growth rate of 10%, $25,000 would turn into over $436,000. By cashing out your 401k early, you would lose almost half a million dollars. In retirement years, that’s a devastating consequence that can make life much more difficult.
Is Cashing Out My 401k Ever a Good Idea?
As a coach, I have found that there are two exceptions to this otherwise rigid rule: avoiding bankruptcy or foreclosure.
Both bankruptcy and foreclosure are extremely heavy burdens to bear. A Chapter 7 bankruptcy will clear one’s debts and wipe the slate clean. But the bankruptcy trustee takes away certain assets for liquidation. One may reaffirm certain debts, such as cars, but the debtor still owes the creditors for those debts not liquidated in the Chapter 7.
A Chapter 13 bankruptcy is a three-to-five-year payment plan where the debtor gives a large portion of financial control to the Chapter 13 trustee. It is difficult to do anything during this time, even a debt snowball, so I strongly recommend avoiding bankruptcy in nearly all circumstances.
Foreclosure is also a devastating experience. Imagine losing the home you’ve lived in for years, made renovations on, and in which you dreamed about raising your family. The foreclosure sweeps that away, wrecks your credit, and uproots stability in your family’s life. It can take years to get back to the point of even being creditworthy to get a mortgage again.
Normally, I do not suggest cashing out a 401k to pay off debts. But 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 necessarily as high as bankruptcy or foreclosure.
Final Thoughts
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.
During my time coaching, I’ve only had one client (so far) who really had to cash out their 401k to avoid bankruptcy. It was a very hard choice, but filing for bankruptcy would have been so much worse.
Bankruptcy is a tremendous blow to one’s financial journey, especially if the filing is for Chapter 13. There are a lot of considerations with bankruptcy, which I discuss here.
That’s a fate I don’t want for anyone. If it requires cashing out your 401k, that’s something we can discuss to see if it really is the better of two bad options.
Reach out to me today so we can talk about the best path moving forward. Set up your free Discovery Session to break free of the financial burdens that have held you down. The past doesn’t have to define your future. And the future starts today.
