It is quite common for prospective clients to call my office and tell me that they are considering taking out a loan from their retirement account, or withdrawing money from their retirement account, in order to pay some of their creditors. I’ve also had people hire me to file their bankruptcy a year or so after doing this. Usually they took out that loan or withdrew that money in order to pay their creditors (and avoid filing bankruptcy). Yet, even after doing that, they are finding themselves in a situation where filing bankruptcy makes sense for them.
My first piece of advice is: don’t do it! For most people, it’s usually not a good idea to take money out of their retirement accounts to pay their creditors.
If you are going to withdraw money from your retirement account (even though I just told you it’s probably not a good idea) it is in your best interest to consult with an accountant or CPA first. I have seen people “cash in” their 401(k) or their IRA, and use all of that money to pay off some of their creditors. Then, when tax time comes, they end up getting hit with a big tax bill. Usually they have not been withholding at a high enough rate to cover that tax bill, and they have spent all the money that they withdrew, so they end up owing the IRS and the MN Department of Revenue a nice chunk of change – never a fun thing.
Another downside to taking out a loan against your retirement account or withdrawing money from your retirement plan in order to pay your creditors is that the money in your retirement accounts is generally protected in a bankruptcy. It makes me really sad to see people cash in their retirement, only to end up filing bankruptcy. Also, a loan that you take out against your 401(k) isn’t the sort of debt that can be “wiped out” in a bankruptcy, so that loan against your 401(k) doesn’t disappear.
This article provides a nice discussion about considering alternatives to withdrawing from your 401(k). Here’s a link to another interesting article about the increase of people withdrawing from their retirement plans.