When paying off debt is a bad idea

There may be some cases where saving yourself from debt might be worth temporarily suspending retirement contributions. But such decisions shouldn't be made lightly and you should understand the total costs of the decisions you're making.

3. When you're using your retirement savings

If there's anything worse than forgoing retirement savings, it's raiding what you've already stockpiled.

At least once a week, I get an e-mail or letter from someone who has concocted a scheme to tap an IRA or 401k in order to pay off credit cards, car loans or -- heaven forbid -- mortgages.

This lunacy must stop.

Most of the writers honestly have no idea how much they'll lose to taxes and penalties if they withdraw this money.

It can be a lot of money: Depending on your state and federal tax bracket, you'll typically sacrifice one-quarter to one-half of whatever you withdraw.

Even if they do understand the tax cost, they give short shrift to how much they'll lose in potential returns. Once the money's withdrawn from a retirement plan, you can't put it back, and you've lost all that lovely future tax-deferred compounding.

Some folks understand that outright withdrawals from a retirement plan are a bad idea, but try to make the argument that it's better to borrow from themselves -- via a 401k loan -- than to continue paying interest to a credit-card company. But I wonder how many of these people are using 401k loans to avoid their real problem, which is overspending.

There's an additional, hidden risk of borrowing from your 401k: If you lose your job, you have to pay back a 401k loan in short order, or it will be taxed and penalized as a distribution.

Furthermore, if worse comes to worst, your credit-card debts can be wiped away in bankruptcy. Instead, you've essentially secured that debt with your retirement plan.

4. When it's hopeless

When I first started writing about personal finance, I was inspired by tales of people who had paid off mountains of debt in short order. They got their lives on track and felt satisfaction from their accomplishments. I still believe, for most people, such happy outcomes are possible.

Since then, however, I've seen the other side -- people struggling with bills that are simply impossible to pay off. They empty their retirement funds, tap their home equity and scrape for years to pay enormous medical bills, bad business loans or credit card debt. Many continue paying long past the point it makes any sense, with no real hope of financial recovery.

Some got slammed with accidents, disease, job loss, divorce or other setbacks. Others brought it on themselves through stupidity, ignorance, greed or bungling. There's usually plenty of blame to go around, and some of it belongs to a financial system that keeps spewing out credit to people clearly unable, for whatever reason, to handle it.

So I'm not a fan of bankruptcy, but there's a reason why it's there. Bankruptcy court is designed to give people a fresh start and to protect their essential assets, including homes and retirement funds, so that they don't have to face a destitute old age. Bankruptcy is not a perfect solution, nor even a good one, but sometimes it's the best of some very bad options.

How do you know if you've reached this desperate pass? It can be tough. Credit counselors are, after all, in business to convince you to pay off your debts, while bankruptcy attorneys are in business to help you file for bankruptcy court protection. You probably should talk to both before deciding what to do next. (Also see MSN Money's Bankruptcy Guide.)

Your decision may be made for you. Affiliates of the National Foundation for Consumer Credit, the oldest credit counseling network, say they turn away somewhere between 3% and 10% of those who seek help because they're simply in too much debt to repay their bills within the foundation's three- to five-year guidelines.

• Talk back: Get free help now -- Ask a Credit Counselor

The folks who don't make the grade usually aren't told directly to file for bankruptcy; instead, they're told in code to "seek legal advice."

So if you're told by credit counselors that you're beyond their help, it's probably time to file.

Liz Pulliam Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "Your Credit Score: Your Money & What's at Stake." Weston’s award-winning columns appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.

Updated June 16, 2009

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