How far should you go to pay off debt?

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The recession has been tough on everyone. Even many of those who kept their jobs may have resorted to using credit cards and other lines of credit to offset salary cuts or pay for unexpected expenses.

If you’ve found yourself overextended with your credit, you may be tempted to liquidate your long-term savings, such as cash values on life insurance policies and your 401(k) or IRA accounts, to pay off debt. And then you might be able to pay off only part of your obligations.

Is it worth it?

Analyze the tradeoffs

“It really depends on the type of debt and if it will free up some cash each month,” says Ryan Michler, registered representative for McPartland Group Financial Services in St. George, Utah. “Your goal is just not to eliminate debt, but to get cash flow once again.”

For example, Michler says, if you are liquidating assets to put toward your home loan, but not paying it off, it will not free up extra cash since your payment amount doesn’t change and will do nothing to improve your current financial situation.

“However, if it is an open line of credit or a revolving account and you’re liquidating $50,000 to pay off a significant portion, say $80,000 in debt, then you are freeing cash and you can begin reducing the rest of the debt or saving again,” he says.

Michler adds that strapped consumers should also consider these factors when deciding whether to liquidate assets to pay off debt:

  • Take into account the tax consequences and penalties on 401(k) plan withdrawals for money distributed before the eligible age.
  • Cashing in a large sum of money could bump you to another tax bracket.
  • There could be surrender charges on life insurance.
  • Cashing your life insurance could leave your dependents unprotected should something happen to you and you are not able to buy another policy.

An unexpected delivery

George Rapp hadn’t had a raise in at least three years when his employer was bought out in 2008. After the buyout, Rapp, a manager in the technology industry in Columbus, Ohio, was asked to take a 10 percent pay cut, along with his co-workers.

“That in itself was survivable,” says Rapp. His wife then experienced a difficult third pregnancy and after a couple of hospital stays, delivered the baby 14 weeks early in the spring of 2009. Medical bills quickly ate up the maximum on their health insurance, and there were child care expenses for their two older children while the Rapps stood vigil at the hospital. “The incidental expenses, such as eating out two or three times a day, made for a really expensive spring and summer,” says Rapp. His wife, a contract employee working from home, lost her job.

Rapp says they aren’t behind on their bills. “We’re just stuck in that cycle of making minimum payments,” says Rapp. The family is approximately $100,000 in debt. Rapp’s 401(k) is worth about $105,000. However, penalties and taxes would eat a large percentage of the withdrawal, plus Rapp had previously taken out a 401(k) loan that remains outstanding.

The 43-year-old says he cannot file bankruptcy or do anything that would harm his credit, as his employer pulls credit checks routinely. He also says he isn’t concerned about retirement. “I’ve come to the realization that 65 is really a mythical age for retiring anymore,” says Rapp. “I plan on working into my mid-70s.”

Other considerations

“I usually advise people not to cash in their 401(k), IRA, life insurance or sell their home,” says Greg McGraime, a Certified Financial Planner with PricewaterhouseCoopers in New York City. “If they cannot eliminate all or a very significant portion of their debt, they usually end up going through bankruptcy later anyway.”

McGraime says that most long-term assets are protected in bankruptcy, but if they have been liquidated to pay off debt, you’re left with absolutely nothing if you have to file bankruptcy later. “People have to look at the total picture, assess their tax and penalties and make sure liquidating their assets will help them get back to a normal financial situation,” says McGraime.

McGraime says people should assess what got them in that situation in the first place. “Were you spending more than your income allowed, or was it a one-time catastrophic event, such as job loss or a medical situation?” he says. “If it was a one-time event and you can pay your debt off, then it might be the right thing. However, if it’s an ongoing thing, liquidating assets and paying off the debt may only relieve the pressure, and without changing habits, you could find yourself back where you started.”

McGraime says if you decide not to liquidate assets and you cannot handle the debt on your own, you should seek the advice of a not-for-profit consumer credit counseling agency associated with the National Foundation for Credit Counseling or a bankruptcy attorney.

“There’s nothing worse than seeing someone scrimp and save for five years and not be able to make any progress. There’s no downside with consulting with someone to learn all of your options,” he says.