People who are laid off of good jobs with corporations often figure that the lay off is temporary and that they should not have to make significant changes in their life style, or let the kids know that times are hard and, so, they tap into their 401K retirement savings in order to float the boat until things turn around.
But, because times are tight they either under withhold or pay none of the taxes and penalties that go along with withdrawing that money. After all, they figure that since they are not making money their income tax liability will be less anyway. Of course, this is wrong thinking.
401K money is “tax deferred” money. That is to say, it was not included in your income in the year that your employer paid that money. So, when it comes out, it is income. If you take money out at the velocity that you were earning not only will there not be “less income” for the year but, because there is a penalty on early withdrawals from tax deferred savings accounts, your taxes will be higher than they would have been.
If that is not bad enough, the really bad part is that the credit cards that were paid using the withdrawn funds were, in almost all cases, fully dischargeable in a bankruptcy case but the tax liability incurred on the 401K money withdrawn to make those payments cannot be discharged in bankruptcy for years.
Whenever someone is laid off they should consider consulting with a bankruptcy attorney as their first move. Even if Bankruptcy is the last resort, knowing how to make wise choices in preparation can make all the difference.