In this tough economy, there are many people struggling with the decision of whether to cash out retirement funds to pay off debt or consider the option of bankruptcy. While bankruptcy still has some stigma attached, that stereotype is vanishing as more and more people find themselves desperate and without other options.
One of the main advantages available to a borrower in Chapter 7 bankruptcy is the discharge of debts. A Chapter 7 bankruptcy discharges the borrower from personal liability for certain specified types of debt. In other words, the applicant is no longer required by law to pay any liabilities that are discharged. The discharge functions as a permanent order directed to the creditors included in the bankruptcy and requires them to refrain from proceeding with any form of a collection action on the discharged debts. The court order includes any legal action and contact with the applicant, such as telephone calls and letters. This is known as an automatic stay.
There may be disadvantages to filing for bankruptcy. Bankruptcy will have a negative impact on your credit. As a matter of fact, it can stay on your credit report for up to 10 years. However, it will not take 10 years to regain a good credit score or qualify for prime rate loans. Typically, after about two years, a person who has filed Chapter 7 bankruptcy can finance the purchase of a home with a good interest rate. In less time than that, it is possible to purchase a car with a reasonable interest rate.
What about the downsides to paying off debt using retirement funds or settling delinquent accounts? Though it may not seem logical, there are several disadvantages: Your credit will suffer if you have settled accounts that are not paid in full. The impact will not be as severe as a bankruptcy, however your credit will be heavily impacted from any delinquent payments prior to settling the debts.
You can be taxed on the amounts your creditors write off. This is called cancellation of debt income. The creditor can send you a 1099 at the end of the year for any amount that was written off. You may be required to claim that amount as additional income for tax purposes and pay more taxes as a result.
You may deplete an asset that you will need in the future. Retirement plans are completely protected from your creditors when you file bankruptcy. This is probably the asset that is most crucial to protect because it means security for your future. Unfortunately, we won't be able to rely on Social Security forever, so it is important to protect your savings in order to live comfortably in retirement.
While settling debt can be a good alternative to filing bankruptcy, it is important to know the consequences. Far too many people use their savings to try to get out of debt, only to find that they are not able to settle all of their outstanding accounts and end up filing bankruptcy in the end. Before proceeding in either direction, it's important to get the right advice so you can investigate your options and consider the pros and cons in order to make an educated decision that is in your best interests, especially in the long-term. If you have questions about filing for bankruptcy I offer a free 30 minute telephone bankruptcy consultation where we can discuss your debt situation and work out a plan of action.