Bad Idea #1: Cashing Out a 401(k) to Pay Off DebtPosted on May 8th, 2011 William No comments
These days, a lot of people are working to pay down debt, which is a great idea; few things are more stressful than owing money, so paying off your debts not only helps you to have a better retirement, it can have positive benefits on your health right now.
Still, that doesn't mean that paying down debt is always the best option. One particularly bad idea is to cash out a 401(k) plan to pay off your debt.
Why is that a bad idea? Here are the three biggest reasons:
1) The money is supposed to be for retirement! If you pull it out now, it may look like a smart move - after all, you're probably paying more interest on your credit card than you're making on your retirement plan - but it's a lot easier to ignore your retirement account being too small than your debt being too big (at least until you get close to retirement!) You should make a practice of never touching your retirement funds if it's at all possible; once the money is in there, it's off limits.
2) The government will even help enforce that practice; if you haven't reached retirement age and you try to take money out of your retirement account, you're going to face some hefty penalties and interest (with the exception of principle on a Roth IRA, of course). Just by taking the money out of your account, you could end up losing a third of it immediately, before it even has a chance to do you any good.
3) Retirement funds (up to a certain limit) are exempt from bankruptcy. If your debt gets the better of you and you're forced to declare bankruptcy, you can shed the debt and keep the retirement funds. As such, even when things feel hopeless, it's still best to leave the money in your 401(k) alone if at all possible.
Of course, sometimes there really is an emergency - most likely medical - that completely justifies pulling the money out; in this case, you may even be able to avoid the early withdrawal penalties. However, consider your options carefully; not having adequate retirement savings is always a bad idea!