Cash out 401(k) or file bankruptcy?

Dear Bankruptcy Adviser,
I lost my job and have used all of my severance money. I have $55,000 in credit card debt. Should I use money from my 401(k) or file bankruptcy? My 401(k) total is around $55,000. I realize I will have to pay taxes and penalties for an early withdrawal.
— Mary

Dear Mary,
This is a tough, tough question; one that I get quite a bit. I will present both sides of the argument on filing bankruptcy, and you can make your decision based on as much information as possible.

Disadvantages of bankruptcy

Bankruptcy leaves a negative mark on your credit report for the next 10 years. You can recover and have a very good credit score before the 10-year period is over, but the word “bankruptcy” will appear on your credit report for the next decade. There is no legal way to remove it.

You likely could withdraw the entire 401(k) funds and after the 10 percent penalty plus income tax liability, you would still have around $35,000 or more. With that money, you could try to settle your debts. That means you could pay less than the balance owed. Settling a debt does have a negative impact on your credit score, but not as negative as a bankruptcy.

Please note that if you settle the debts, you will have to report the difference between the actual balance and settled amount on your taxes. For example, you have a card on which you owe $10,000 and you settle the debt for $4,000. You will have to report the $6,000 difference as debt forgiveness income on your tax returns. This could result in tax liability.

You also could have difficulty finding future employment with a bankruptcy on your credit. Some prospective employers would discriminate against you because of it. Obviously, the employer would not outright say that, but if considering two applicants with similar resumes, the one who did not file bankruptcy may have the edge.

Re-establishing credit after bankruptcy is not as difficult as people think, but you will have to work and deal with a few rejections before you begin to rebuild. I promise that you can have an excellent credit score again.

Advantages of filing bankruptcy

You may be able to wipe out the entire $55,000 in credit card debt while keeping every penny of the 401(k) money. The 401(k) money is exempt in a bankruptcy, so the funds cannot be taken in order to pay your creditors. As long as the money is still in the 401(k) account at the time you file your case, those funds would be protected. That is important to remember. Do not take the money out of the retirement account, put it in your bank account and then file bankruptcy.

You might be a perfect candidate for a Chapter 7 bankruptcy, and this $55,000 in your 401(k) would be important to your life after retirement. You can always rebuild your credit, but you cannot as easily get that $55,000 back. Reaching that balance may have taken you years, and getting your credit score back above 700 will take much less time.

It is hoped that this gives you the insight to make an informed decision.

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