Is it Better to File Bankruptcy or Deplete a 401(k) to Prevent Bankruptcy?

Filing bankruptcy is one option for dealing with unpaid debt.
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If you're very deeply in debt, filing bankruptcy may be one way out. But, for some debtors, another solution -- like cashing out a 401(k) or other retirement savings to pay down debt -- is a preferable alternative to bankruptcy. If you're weighing either of these options, consider the pros and cons of each before making a decision.

Benefits of Filing Bankruptcy

The primary benefit of filing bankruptcy is that it gives you a plan for eliminating your debts. If you file Chapter 7, you can discharge any amount of secured or unsecured debt and be debt-free within a matter of months. If you file Chapter 13, you get more time to pay down your debts and you don't risk losing any of your assets to the bankruptcy court. Filing bankruptcy also enforces an automatic stay against your creditors, which means they can't attempt to sue you, garnish your wages, put liens on your property or seize your bank account until your case is resolved.

Bankruptcy Disadvantages

The primary downside to filing bankruptcy is the damage it does to your credit. A Chapter 7 bankruptcy can stay on your credit for up to 10 years. A Chapter 13 filing can stay on your credit for up to seven years. Depending on how good or bad your credit was before you filed, it can take anywhere from six months to two years for you to see an improvement in your credit score. Following your bankruptcy discharge, you may find that it's difficult to get approved for new credit or loans. If you are approved, you'll likely end up paying more in interest until your credit score improves.

Pros and Cons of 401(k) Loans

When you take out a 401(k) loan, you're essentially borrowing from yourself. You agree to pay back a certain amount of money each pay period along with any interest you're charged for the loan. If you have a significant amount of high-interest debt, taking out a 401(k) loan may actually save you money in the long run in terms of the interest you'll avoid paying.

The primary disadvantage of taking out a 401(k) loan to pay down debt is that if you lose your job, the remaining balance of the loan becomes due immediately. In addition to having to repay the loan, you may have to pay a 10-percent tax penalty as well as regular income tax on the distribution.

401(k)s and Bankruptcy

Retirement accounts, including 401(k) accounts, are protected under federal bankruptcy exemption guidelines, meaning these assets can't be seized to repay your debts. State laws on 401(k) exemptions vary, but most states also exclude these accounts from the bankruptcy estate.

Take note that 401(k) loans cannot be discharged in bankruptcy and you also won't be able to discharge any taxes or penalties you incur for the distribution. If you take out a 401(k) loan but end up declaring bankruptcy, you'll still be responsible for repaying the money after your case is discharged.

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