I am often asked by prospective clients whether it is wise for them to use their 401k to pay off their credit cards, medical bills and other debt or to catch up on their mortgage payments. Although I am not a tax attorney or a financial advisor, what I do tell them is that unless they qualify for a hardship (see below), a withdrawal from their 401k will result in them being taxed at their regular income tax rate and they will also be penalized 10% of the amount of the withdrawal. However, if they do qualify for a hardship, the distribution will be taxed as Gross Income but they will not have to pay the 10% penalty. A better alternative might be to take out a loan against their 401k if their plan allows them to. The advantage of a 401k loan is that there will be no tax ramifications or penalties.
In terms whether one qualifies for a hardship depends on the following:
"[w]hether a need is immediate and heavy depends on the facts and circumstances. Certain expenses are deemed to be immediate and heavy, including: (1) certain medical expenses; (2) costs relating to the purchase of a principal residence; (3) tuition and related educational fees and expenses; (4) payments necessary to prevent eviction from, or foreclosure on, a principal residence; (5) burial or funeral expenses; and (6) certain expenses for the repair of damage to the employee's principal residence. Expenses for the purchase of a boat or television would generally not qualify for a hardship distribution. A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee."
IRS Reg. §1.401(k)-1(d)(3)(iii)
Paying off credit cards will not qualify for a hardship distribution. So, generally, it would not be wise to take a distribution from a 401k to pay off credit card debt because of the tax and penalty ramifications. However, if the conditions are met to qualify for a hardship distribution, using the 401k funds to pay certain medical bills or to catch up on mortgage payments is a viable option. But, the amount of the distribution will be taxed as Gross Income. And, although this is a short term solution, they may not feel the effects until down the road...when they need the funds when they retire.
Other alternatives to taking a 401k distribution or a loan against a 401k are Chapter 7 or Chapter 13 Bankruptcy depending on the individual's overall financial situation. A Chapter 7 will discharge credit card bills, medical bills and other unsecured debt. A Chapter 13 is a repayment plan that allows one to repay back the defaulted mortgage payments and a percentage of their unsecured debt over a 3 to 5 year period. If you are experiencing financial difficulties, it is always wise to seek legal advice from an experienced bankruptcy attorney to discuss these and other options.
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