In Bankruptcy, Do You Actually Have to Pay Debt With Your 401K Funds?

If you are considering filing for personal bankruptcy, are you forced to pay debt on your cards with 401k retirement savings?

The fear of losing their 401k leads many consumers to avoid filing for bankruptcy even when it is the only option left for them to rid themselves of credit card debt.

If you are struggling each month to pay even the minimum amount due on your credit card debt if may seem like a good idea to take a loan against your 401k and use that money to pay off credit card debt.

Filling For Bankruptcy

If you are filing for Chapter 7 bankruptcy you will not have to pay off debt when you file for bankruptcy protection. Your 401k is exempt from being listed as an at risk asset as long as you have not cashed out that 401k savings plan.

One of the first things many people do when burdened with credit card debt is to take a loan on their 401k balance. On the face of it, this would seem to be a good way to pay off your cards but there can be serious pitfalls.

A 401k loan is easy to obtain because you are loaning money to yourself. Most financial experts advise never to take a loan against your 401k.

When you do this you risk losing the matching funds your company may provide. This is not as great an obstacle today as many companies have stopped matching 401k contributions in this tough economy.

A 401k loan must be repaid. Though it is true the money belongs to you, failure to repay the loan in a specific period of time can lead to serious tax problems as the money will be counted as income.

If you are less than 59½ years of age you will pay a 10% penalty for withdrawing money from your 401k if repayment is not forthcoming.

If filing for Chapter 7 is a possibility in your future, it is not a good idea to take a loan from your 401k as a stopgap measure to temporarily avoid bankruptcy.

If you turn your 401k plan into cash by withdrawing money from it, you may create an income that will disqualify you from filing for Chapter 7 bankruptcy.

As long as your savings remain in your 401k plan, the money is safe and is exempt during a bankruptcy proceeding.

Using a 401k Loan

The most common reason for huge credit card debt is lack of financial management and simple over spending. If that is not your problem, a 401k loan to pay off your debt may be a financially smart move.

Depending on how much you borrow form your 401k account, you will have 2-5 years to repay that debt. You don't have to worry about qualifying for the loan as you are loaning to yourself. The interest rate is low and you are also paying the interest to yourself.

You will lose out on any market gains that might have resulted from that money that was invested and is now on loan. You may lose out on matching funds from your employer during the period of the loan.

However, if you are struggling to pay off debts that are a result of a life changing emergency, this is one option that is open to you.

If you understand your debt is the result of overspending and under budgeting, are you then forced to use your 401k?

Of course not and you should not take that path until you have created a workable budget that will avoid making the same mistakes of overspending going forward.

Summary

Your best option when you have problems paying debt is to leave your 401k money in place in the retirement account. Unless you are convinced you can pay your debt and not create more debt in the future, you should not take out a 401k loan to pay credit card debt.

If you are facing potential bankruptcy in the near future, do not remove money from your 401k or you may reduce your ability to obtain bankruptcy protection.