Insolvency makes people face a lot of difficult questions, and one of the most challenging is whether to pay off your debts now even if it virtually guarantees you'll be in financial trouble later. For example, if you're trying to deal with credit card debt and the only savings you have are in a retirement account, should you liquidate that 401(k) to pay off the credit cards?

For most people the answer is no. Even though credit card debt is expensive, the costs of borrowing from your 401(k) or IRA probably far outweigh what you'd save on interest.

More important, your retirement accounts are an essential asset that takes years to build. For most Americans, they're the only way they'll be able to pay their expenses once they retire, and the only way they'll be able to save enough for those years is to start early and save consistently over the years.

Consider the Net Costs of Cashing Out Your 401(k) Plan

Say you had $1,000 in a regular savings account that was earning you 1 percent interest and you had $1,000 in credit card debt that was costing you 10 percent interest. All other considerations aside, financially it makes sense to use your savings to pay off the credit card because, as it stands, keeping the money in that savings account is actually costing you a net 9 percent.

On the other hand, if the savings account paid you 10 percent and the credit card cost you 1 percent, it makes more sense financially not to use the savings to pay off the credit card. In fact, you might want to borrow more from the cheap credit card and invest it in that high-return savings account -- you'd come out ahead.

With a 401(k) account, however, it's not that simple. These and some other retirement savings accounts have tax advantages to encourage you to save. In many cases, you get to put money into the account before any taxes are taken out of it.

When you take money out of such an account before retirement, you have to pay taxes on it. Additionally, you will have to pay a 10 percent penalty for withdrawing the money early.

Practically what that means is this: In order to get $30,000 out of your 401(k) account that you can use to pay off credit card debt, you actually have to withdraw $46,000. The other $16,000 will disappear forever in the form of taxes and penalties.

So, before you make the very expensive choice of using your retirement account to pay off credit card debt, talk to a credit counselor or a bankruptcy attorney to find out what your options are.

Source:

"Don't retire card debt with 401(k) savings" (To Her Credit blog, CreditCards.com, July 23, 2010)