• 17
  • September
    2010

Dealing with problems such as outstanding medical bills, rising mortgage payments, and impending foreclosures are incredibly stressful for most people. When faced with these types of problems, it is important to take the time to make good financial choices in order to prevent making mistakes and digging an even deeper hole for yourself.

In attempts to deal with their financial difficulties, many people are choosing to make withdrawals or take loans from their 401(k) retirement accounts. While this may seem like a good short-term solution to your money problems, using your retirement funds to pay your bills can have some very serious drawbacks. If you or someone you know is considering tapping a 401(k), it's worth taking some time to consider the negatives and weigh some other alternatives.

There are generally two types of withdrawals from a 401(k) plan, a "hardship withdrawal" and a loan. Both of these options have their own downsides, so let's talk about them separately. A hardship withdrawal is only available under certain circumstances. The IRS allows an individual to withdraw money from a 401(k) for items such as tuition payments, purchasing a primary home, paying medical bills, and preventing home foreclosure.

Some of the drawbacks of a hardship withdrawal include the potential for tax liability or early withdrawal penalties and the loss of the ability to contribute to your savings. Once an individual takes a hardship withdrawal, he or she will generally pay income tax on it as they would with other income. In addition, if under the age of 59.5, you will typically have to pay 10% early withdrawal penalty.

Those that withdraw money are also prohibited from making new contributions to the fund for a period of time. That means you will miss out on interest and on matching funds from your employer. In the end, you lose the money you withdrew, but you also lose money you could have been earning.

Perhaps the most troubling part of tapping into 401(k) and retirement savings is that these investments are generally protected from credits in the first place. Your retirement is protected from creditors by federal law; the only way a creditor is going to get to that money is if you give it to them. Before you do that, you may want to talk to an attorney and consider bankruptcy options as a way of dealing with medical bills and stopping the foreclosure process.

In our next post, we will talk a little more about the problems with 401(k) loans and your other options for dealing with debts.

Related Resources:

Thinking about raiding your 401(k) plan? Don't do it. (USA Today)