Stop! Never Withdraw From Your 401(k) To Pay Creditors

A reader recently wrote us asking, “My husband had a serious medical issue last fall. We owe several different providers $84,000 in total. We have 401(k)s from our jobs (my current one and his old one). Can they legally take our investments? We have no other money to give them. Because of his medical issues, he hasn’t worked since last summer. My mom has helped us out since then.”

We’re sorry to hear about your troubles, and hope your husband recovers soon.

We also feel for you– your anxiety is apparent. After you finish reading this, check out our article about how to cope with stress and depression caused by debt.

Now for the good news – creditors cannot seize money you’ve socked away in your 401(k). “Federal law mandates that money in your 401(k) plan or other employer-sponsored qualified plan, is safe from creditors,” says Dana Anspach, a retirement counselor and the founder of Sensible Money. “Creditors cannot seize your 401(k) assets for medical bills or for any other reason.”

The only people who can take what you’ve saved for retirement is the IRS. “They can seize 401(k) money for federal tax liens you are liable for,” Dana says.

No matter how nasty letters and phone calls from medical creditors get, under no circumstances should you liquidate your 401(k) to pay these medical bills – or any other debt (the IRS will set up payment plans for tax liens in most cases).

If you make an early withdrawal from your 401(k) before the age of 59 and a half, you’ll have to pay your usual tax rate on the amount you take out, plus a 10% fee.

These fees add up fast. (To figure out just how much money you’ll lose if you make an early withdrawal from your 401k, use this calculator.)

You and your husband may qualify for what’s known as a “hardship withdrawal.” According to the 401k Help Center, hardship withdrawals are usually granted if you meet one of the following criteria:

• Un-reimbursed medical expenses for you, your spouse, or dependents.
• Purchase of an employee’s principal residence.
• Payment of college tuition and related educational costs such as room and board for the next 12 months for you, your spouse, dependents, or children who are no longer dependents.
• Payments necessary to prevent eviction of you from your home, or foreclosure on the mortgage of your principal residence.
• For funeral expenses.
• Certain expenses for the repair of damage to the employee’s principal residence.

But you have to withdraw the money the same year the medical bills were incurred. And you’ll still pay that 10 percent fee, unless the medical expenses exceed 7.5 percent of your adjusted gross income.

And don’t forget the hidden costs of taking money out of your 401(k).

The money you have in your 401(k) should (ideally) be accruing dividends, which then are reinvested in that account.

If you take money out of your 401(k), you’re robbing yourself of future earnings on that money.

The earnings should be substantial. According to Fidelity, a $5,500 IRA contribution with an average annual return of 7 percent could translate to $58,721 35 years later.

Here’s some more good news. Doctors and hospitals are usually pretty cool about allowing you to pay off what you owe over time.

Medical providers will usually set up an interest fee payment plan to collect any money you owe them.

I owed over $6,000 in medical bills after my daughter’s premature birth. I pay them $35 per month – an amount they can live with, and I can live with. It’s easy to come to work out a payment plan for medical debt – I didn’t have to give them a sob story when I called to set up the plan, or show them any bank statements, tax returns, or pay stubs.

If you think you don’t even have $20 to spare, so you may want to look into any financial assistance plans the provider offers. There’s a lot of paperwork involved, and you may not qualify depending on how much you make at your job, but it’s worth looking into because they may forgive your balance entirely.

Another thing – don’t beat yourself up about this debt. You didn’t incur it spending too much money on clothes and dining out.

You sound like you’re fiscally responsible. You and your husband both contributed to your 401ks, and you learned how to ask family for money when you needed help.

I hope you had an emergency fund to help you whether some of these hardships. If you didn’t, or it’s empty, it’s not too late to start a rainy day fund now, even if you’re a one-income household.

We even have a calculator to help you figure out how much you should be putting aside each paycheck.

Hang in there, and let us know how you’re both doing.

Have you had any medical debt, or money seized from a creditor? Tell us in the comments.