Financial Planning for Generation X & Y Women
 
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Expert Q&A Archive

01/17/2008
Should I cash in my old 401k to help with my debt?
I recently changed employers and have $12,000.00 in a 401k with the previous job. I have until March 2008 to rollover this money or take the cash. I would like to take the cash and use this money to get out of debt. I owe about $3000.00 in unpaid boro wage taxes from 2004 to present, $900.00 to gas company (I am on a budget plan and current with payments) and I have several other bills that round out to about another $2000.00. Also, my home needs some repairs (a new windows, side and back doors, kitchen sink and bathtub/shower). My credit rating is very low because I filed for bankruptcy in August of 2006 with a 60 month repayment plan at $460.00 semi weekly(which they are going to increase to $560.00 starting this month) deducted directly from my pay. My take home pay after the payment plan and other deductions is $250.00-$300.00. What should I do and what are my options?
Alyssa Rakovich:
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If you take the $ it will be taxed as ordinary income - so it may put you in a higher income tax bracket - also if you are not 59 1/2 or older you will also pay a 10% penalty for early withdrawal - So, the cost of taking the money out is very high - for example if you are not 59 1/2 or older and are in a 28% tax bracket you would net $7440 – $4560 in taxes and penalties.
Jody Rorick, CPA:
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I don't know your age or your tax bracket, but if you could possibly manage your debt without cashing in your 401K, that would be a better financial decision. It has a special tax status, since you don't pay any tax on interest or dividends, until you withdraw it. That means it grows tax-free, at a compounded rate. If you cash it, you lose all this. No matter what your age, you should save for retirement. You should work very hard on paying your bills on time, try not to overspend, postpone your home improvements, so your credit score is improved. Try to make a budget and stick to it, and always try to earn as much as you can.
Michael A. Masiello:
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File this under tough love, no do not take the cash, for a number of reasons, first 10 % penalty plus income taxes for premature withdrawal, secondly that money won't be working for you for retirement. It sounds harsh but it is better to roll over the 401k and use cash flow and spending
discipline to get out of bind. Mike.
Rosemary Ervin, CPA:
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If you are over age 59 1/2, you can take the $12,000 to get out of debt and make your improvements. If you are under the age, it will cost you an extra $1,200 penalty before taxes. Not a good idea, considering that $1,200 means a lot to you. You do not have too many options to cut your expenses, is it possible to increase your income by taking on a part-time job?

If you cannot pay down some of your debt, the interest accumulating on the balances will overwhelm you. You are in a posture whereby you are paying currently for expenses that incurred in the past, not a good position to be in. You can take some of the $12,000, say $5,900 to get you out of debt, and pass on the home improvements until you can afford them. If you take about $6,500 of the $12,000 to pay the 10% penalty ($655 + $3,000 + $900 + $2,000) and get out of debt. That would leave you with about $5,500 to roll into a retirement plan.

Hope this helps to get you on the road to financial freedom.
Bettye J. Banks:
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I trust you have learned the financial skills you need to avoid bankruptcy in the future. If you need additional assistance, contract an accredited non-profit credit counseling agency. It makes sense to get out of debt as quickly as possible. Unpaid bills (and especially unpaid taxes) can be truly problematic. Remember though, that you will have a tax hit if you take the money out now. Consult your tax advisor about the amount you can expect to lose. You may also incur a penalty if you're under age 59 1/2 at the time you withdraw the funds.
Claudia James:
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It sounds like cash flow is an issue for you, if this is the case some of the debt needs to eliminated. I suggest you pay off the boro taxes, the gas bill, and the miscellaneous items totaling $2,000. Also, I would set aside $1,000 for the home repairs which will probably not cover all of them, so you'll need to prioritize. For the repairs not covered, I suggest you come up with some creative ideas for getting them done, i.e.; bartering. This should leave you with a small amount to roll over-keep in mind that the 401 balance of $12,000 is not the amount you'll have access to-you'll probably encounter a tax liability as well as a penalty for early withdrawal.
Kenneth Shapiro, CPA/PFS, CFP :
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Based on the limited information provided, the first thing to do is to determine your financial priorities. While other advisors may not agree with me, it seems that improving your cash flow and credit score should be top priority. Minimizing your tax consequences is also a valid objective, but I believe it should be secondary to getting your finances back in order. Some funds should also be set aside to begin accumulating an emergency reserve fund for yourself.

Your thought about taking your 401K distribution and paying off the your bills is therefore a viable consideration. If you are under 59 1/2, early distribution will result in a 10% penalty on the proceeds. My guess is that you are in a low marginal tax bracket however, so the combined tax consequences might approximate 20% or $2,400, leaving you with $9,600 in net proceeds.

[For a clear description of marginal tax rate see “Top things to know,” at CNNMoney.com.at http://money.cnn.com/magazines/moneymag/money101/lesson18/index3.htm.]

Taking the distribution directly from the 401K will probably result in having 20% federal tax withheld, thereby eliminating the concern that you might spend the tax money & not have it available when you needed upon filing next year's tax return.

A second option would require you to be more responsible about managing your savings. You could request a direct transfer of the 401K directly to an IRA account, and take your distribution from there. The $2,400 is not required to be withheld on distributions from IRAs, so you will have more money to address your needs now. You should then put money aside each month to rebuild the $2,400 in case it is needed to satisfy the tax liability due for taking the premature distribution.

The third option to consider is taking a loan with your new company's 401K, if one is available. You should be able to take a loan against the vested amount ($12,000) but may have a one-year waiting period depending on the plan requirements. The interest rate should be lower than bank rates, and interest and principal repayments will be deposited back into your 401k account. Most plans give employees 5 years to repay the loan. The loan proceeds can cover both your outstanding bills and
some of your home repair needs.

Your last option would be to obtain a home equity line [of credit], if one is not already in existence, or refinance your existing mortgage, given the recent drop in rates. This option may be difficult to obtain, however, due to the bankruptcy filing

Hope this helps.
Connie K. Marmet:
expert info »
In addition to normal tax deductions, you will be penalized for the 401(k) withdrawal unless you are over 59 and a half, so the net payment to you will be substantially less than $12,000, and you will have depleted your retirement fund. So think carefully about the withdrawal. Here are some factors to consider (some pros and some cons):
• New jobs generally mean a higher salary. Have you prepared a budget against the new salary and anticipated increases during the remainder for the 60-month repayment period?
• --Is the rate you are paying on your debt substantially higher than what you are earning on the IRA? Do rates of interest on the debt contain a penalty?
• --Are you making progress in reducing the principal?
• --If you use the 401(k) now, are you prepared to stick with a budget that allows you to 1) contribute to rebuilding your 401(k), 2) pay off current debts according to plan, 3) avoid incurring additional debt, and 4) build a positive credit rating?