Avoid raiding retirement accounts to pay credit card debt

And if you withdraw funds early, you'll be smacked with penalties and taxes

To Her Credit columnist Sally Herigstad
Sally Herigstad is a certified public accountant and the author of "Help! I Can't Pay My Bills: Surviving a Financial Crisis" (St. Martin's Press, 2006). She writes "To Her Credit," a weekly reader Q&A column about issues involving women, credit and debt, for CreditCards.com, and also wrote for MSN Money, Interest.com and Bankrate.com, and has guested on Martha Stewart Radio and other programs.

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Question Dear To Her Credit,
We have huge credit card debts ($90,000). My husband has dementia and lost his job, so we have had no choice but to use the credit cards to pay for our living expenses, kids’ tuition and so on. Our credit score is down to 586 due to my husband not paying one of the cards for four months.

I am now in charge of our finances, and I am trying to figure out what to do. I pay the minimum balance each month. We have drained all but one 403(b) retirement account, and I want to take $20,000 out. Should I use it to pay off one card (all are at their limit), or should I spread it to each? I cannot afford to pay any more each month than I’m already paying.  – Debra

Answer

Dear Debra,
Please do not take the last $20,000 out of the retirement account. Draining retirement accounts to pay off credit card debt is almost never a good idea.

If a traditional (not Roth) retirement account belongs to you, and you are not at least 59½ years old, you will generally have to pay a 10 percent penalty for early withdrawal. You also must pay income tax on the amount. By the time you pay both the penalty and tax, you’ve lost a good chunk of the value of the withdrawal.

Worse, if you use the money this year and don’t put a portion aside to pay the tax, you’ll be behind on your income taxes. Now you’ve traded a debt that probably could have been discharged in bankruptcy for tax debt, which generally cannot be discharged.

If the retirement account belongs to your husband, you should be able to avoid the penalty by using the exception for his total disability. However, you still must pay income tax on distributions from traditional retirement accounts.

The biggest reason you shouldn’t take the last drop out of your retirement accounts, however, is that it will then be gone. Right now, the retirement fund is protected from creditors, and it should stay that way. If you take it out, I don’t know how you will manage to put that much back in. You need that money.

Unless you have some assets you can sell to pay off debts, such as an RV or spare vehicle, you may not be able to pay off your cards. You may need to seek relief from the legal system, in the form of Chapter 7 or Chapter 13 bankruptcy. I’m a believer in paying debt, but catastrophic events like these are the reasons we have safety nets and bankruptcy rules. Some circumstances are outside anyone’s control.

Most people think of Chapter 7 bankruptcy, the type that clears all your dischargeable debts as of a certain date. However, depending on your assets and the laws of your state, you may lose some assets in a Chapter 7 bankruptcy. With Chapter 13 bankruptcy, you are given a structure to pay some or all of your debts in a reasonable period of time, using a court-approved plan that you can afford.

Getting rid of the credit card debt won’t solve all your money troubles. If you couldn’t make ends meet without using credit cards before, you’re going to have trouble doing so when the credit cards are closed. You will need to make a budget to see exactly where you stand, and then make some important decisions about what to do next.

For example, you should make sure your husband is getting all the financial and other help he should be receiving because of his disability. Your kids may qualify for assistance with their tuition. Sometimes in situations like these, people decide to move someplace less expensive or closer to relatives who can help out.

To help you look all your options and come up with a plan moving forward, I recommend finding a nonprofit agency affiliated with the National Foundation for Credit Counseling or the Financial Counseling Association of America. You will get through this, but you’ll need help. I wish you all the best during this difficult time.

See related: 7 times when bankruptcy can make sense, 14 key factors when considering bankruptcy

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Updated: 11-24-2017