Bad Move: Used Retirement to Pay Debts; Incurred Taxes; Bankrupt Anyway

Several times over the last few years I have spoken with well-meaning people who have large tax bills from withdrawing retirement money early.   Why the large tax bill?   They withdrew their retirement plan money before retirement age to pay down their debts.  In some cases, these people used their hard-earned retirement funds to pay down credit card debts through so-called "debt settlement" programs.  Others used the retirement withdrawals to make payments on severely underwater mortgages (including wholly out-of-the-money equity lines) on "investment" properties that were actually generating major negative cash flow.  One couple used the retirement funds to pay their full mortgage payment longer they could afford to pay it, when they could have likely obtained a mortgage modification.  

These individuals all had occasion to discuss these matters with a bankruptcy attorney after the fact.  Most of them ended up filing bankruptcy.  All of them would have fared much better if they had met with a bankruptcy attorney first.  How much better?  They would still have the retirement funds growing in their retirement plan.  In addition, they wouldn't owe the IRS early-withdrawal penalties or income tax on the previously tax-deferred withdrawals.  

Why was this such a bad move?  First, these people were using funds that would be exempt in bankruptcy: funds they could have kept despite filing a Chapter 7 bankruptcy, or wouldn't have to account for in a Chapter 13 bankruptcy.  Second, they threw money away:  they used the money to pay unsecured, dis-chargeable debts, or secured, non-recourse debts that would have been scheduled in their bankruptcies.  Third, they incurred tax liability for the early withdrawals, and the tax liability in these instances was not dischargeable when they  later had to file bankruptcy anyway.  Some of them also received 1099 forms for "cancellation of debt" income from the debt-settlement schemes and thought they owed tax on that too.  What a mess.

It is always disheartening to have to explain how much better things could have been - had we only met sooner.  But just remember that using retirement funds to pay debts when you are in severe financial distress is almost always a really, really bad move.  Doing it without getting some bankruptcy advice first is reckless.  The debt collectors and debt settlement schemers on the end of the phone  get paid to try to pressure you into using the last of what you have.  Be careful.