Raiding 401(k) after job loss is risky

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Dear Debt Adviser,
I was let go from my company, had credit card debt and couldn’t find a job. I had to pack up and move in with my son in a different state, so I took out all my 401(k) money to pay my bills and move.

I got unemployment pay for two months until I told them what I had done with my 401(k). Now, I can’t get my unemployment until September 2009. I can’t find a job and I didn’t want to be worried about how I could pay off my bills. I also needed to repay a loan that I had on my 401(k) that my company said I had to pay off because I no longer worked there.

What can I do? How does this work for taxes? I thought I would get unemployment to live on but now I have no income and no retirement fund.
— Pat

Dear Pat,
Your case gives new meaning to the adage “silence is golden.” Still, if they asked you about sources of income, you did right by telling them the truth.

I’m sorry you lost your employment and although I understand why you made the decisions you did regarding your 401(k) account, I really wish you had spoken to your human resources department or plan administrator before you paid off your bills with that money.

It is human nature to want to pay what you owe. However, sometimes it is better to manage your cash flow than eliminate your debts.

It looks as though your unemployment benefits were affected because the money in your 401(k) account was considered deferred salary. When you removed the money from the account, you extended your salary for as many months as the amount that was included in your account.

I don’t know your state laws, but you might try to appeal the ruling, if only for the portion of the distribution that was from your earnings and not as a result of an employer match.

I know it seems very unfair — given that you spent the money you removed from the account to pay back a previous loan on the balance of the account and to pay off your bills — but you did receive the money.

As far as the government is concerned, you received enough deferred salary from your 401(k) to neither need nor qualify for an income source until September 2009. If you haven’t had money withheld for taxes from your 401(k) distribution already, expect to see the amount withdrawn (including the old loan) as income in this year’s W-2. You may also owe a penalty if you are under 59½ years old.

It may be too late, but you might ask your old employer if you qualify under the plan’s hardship withdrawal guidelines to avoid the early withdrawal penalty.

For readers who may find themselves unemployed, please check with the human resources department at your company or the 401(k) plan administrator before making any decisions about your account. You will want to carefully check your state’s rules for collecting unemployment benefits and determine if using any of your retirement money makes sense or if it will only hurt you.

Also, know that when you terminate employment, any money that was borrowed from your 401(k) account becomes immediately due. If you cannot afford to pay it, the amount owed may be treated as a taxable distribution with possible penalties unless you are over age 59½ .

Pat, in some ways you are wealthier than you know. Having a son who will take you in while you search for a job is a real treasure. Many would choose that, over money, any day.