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
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.
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.
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.