The mean credit card debt is $5,700 for households as of 2016 and $14,400 is the median amount of student loan debt. These figures indicate that many Americans are in over their heads when it comes to debt.
Tapping savings, taking out consolidation loans, and even bankruptcy are a few of the steps people take to get out from under an enormous debt load. However, these measures each have pros and cons.
Touch Your Retirement Plans Last, Or Not At All
People who counsel individuals on debt issues have one consistent piece of advice: avoid touching your retirement plans entirely. In addition to the immense value those funds will have once you are indeed retired, the rationale for leaving them alone includes the useful legal shield they possess.
“401(k)s, IRAs, qualified retirement plans, etc. are all protected from creditors in bankruptcy,” notes Jen Lee of Jen Lee Law in San Ramon, CA. Lee says that people often tap those types of savings and still end up in bankruptcy. “ I’ve seen people go through hundreds of thousands of dollars that would have been protected.”
A further downside to pulling money out of a 401(K) or other retirement account is that it becomes taxable. According to the IRS, people pay an additional 10% early withdrawal tax on funds from a retirement plan unless they qualify for an exception. Total and permanent disability is an exception to the 10% additional tax.
Consider Debt Consolidation
When people want to avoid bankruptcy, an alternative they often consider is a debt-consolidation program. This step protects a person’s credit rating and access to credit in an emergency. You can consolidate debt through either a special balance-transfer credit card or a personal loan.
“Debt consolidation is a good option for those with [a strong] credit on_current="true" and that still have good income,” states Jef Henninger, an attorney in Tinton Falls, NJ. He notes that debt consolidation, “generally involves paying off all of your debt by securing a new loan that has a lower interest rate with payments you can afford.”
These programs, however, can have significant drawbacks. “Even though you are enrolled in a debt consolidation program, your creditors still have the right to collect and can bring a lawsuit to collect on these debts,” states Matthew Zimmelman, a bankruptcy attorney from the New York City area. Debt consolidation programs often take their fees off the top before they apply money to the borrower’s debt. So, it is important to “make sure you get everything in writing and understand the terms and, “ If you get served with a lawsuit, it's clear this program is not working for you.”
File for Bankruptcy
Debts may become so overwhelming that filing for bankruptcy can be a viable, even optimal, solution. “It’s time to file for bankruptcy when you can’t even make the minimum payments on debt,” says Jen Lee. Jef Henninger advises that, “Bankruptcy is a better option for people that have bad credit and not enough income for debt consolidation.”
There are two types of personal bankruptcy, Chapter 7 and Chapter 13. “ With a Chapter 7, you will be able to wipe out most of your debt without having to make any payments,” says Jef Henninger. He also notes of Chapter 7, “this will destroy your credit but if it’s already bad to begin with,” the actual damage to creditworthiness maybe minimal.
A Chapter 13 bankruptcy means a debtor is put on a three-to-five-year plan to pay back their debts. He or she makes a payment to a bankruptcy trustee who then pays the creditors. As Matthew Zimmelman notes, “Here you have federal law behind you, protecting you from your creditors as you repay this debt in a 3-5 year plan.” Also, “Chapter 13 bankruptcy is also a key tool to catch up on mortgage arrears and avoid foreclosure.”
How to Avoid Future Financial Trouble
Not surprisingly, attorneys that work with people in deep financial trouble have opinions on how to people can make changes to avoid debt problems again. “ Financial literacy is not taught the way it should be and people are embarrassed at the things they don’t know,” states Jen Lee. Emergency savings, retirement accounts, and insurance are financial tools that help people avoid sinking back into debt.
Jef Henninger agrees that people need to change their lifestyles and how they think about money to avoid repeating the same financial mistakes. He notes, “But it’s like going on a diet. It’s not easy. You have to put in the time to teach yourself.”