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Liquidating 401(k) to pay debts

Dr. Don TaylorDear Dr. Don,
Does it make financial sense to drain a 401(k) and pay off unsecured debt? My reasoning is if I have $17,000 in debts and $20,000 in savings I only have $3,000 net. By paying off the debts I can get out from under the high interest debt. -- Lawrence Liquidate

Dear Lawrence,
Cashing in your 401(k) to pay off your debts is almost always a bad idea. Your 401(k) money is invested in a tax deferred account. Regardless of when you take the money as a distribution, you will owe income taxes on the distribution.

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Take the money out prior to age 59 ½ and you'll owe a 10 percent penalty tax as well, unless you can use the separated from service exemption for a former employee who is 55 or older, or qualify for a hardship exemption.

If you are in the 25 percent marginal federal income tax bracket, and are not yet 59 ½, then you will owe $7,000 in tax and penalty tax on an early distribution of $20,000. Pay off $13,000 worth of that debt and you will have a net of minus $4,000. Now you have no retirement account and still have $4,000 in outstanding debt.

While it's true that you will pay income tax on a distribution regardless of when you take it, so the real difference is the 10 percent penalty tax of $2,000, your $20,000 is still only $13,000 after taxes. Keeping the money invested allows it to grow tax deferred until you need the money in retirement.

Try to avoid liquidating your 401(k) account. Work toward paying down your high interest debt by chipping away at that debt with your monthly payments.

-- Posted: April 4, 2005




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