You feel like you're drowning in credit card debt. And while you can't squeeze anything more out of the paycheck, you may have a tidy sum sitting in your individual retirement account (IRA). Sure, those funds are supposed to stay untouched until you retire. But that's a long way off.
Might it be a better move to use all or part of them now to get those high balances off your back? Read on to find out more about the downsides to using your retirement funds to pay off your credit card debt.
- Withdrawing funds from your IRA is not a wise financial decision.
- Any withdrawals from a traditional IRA before the age of 59½ are subject to taxes and a 10% penalty.
- Roth IRAs limit withdrawal amounts—which are also taxed—and funds must be in the account for at least five years.
- Make sure you use the funds to pay off your debt, and use wise financial decisions so you don't end up overwhelmed by debt again.
First of all, it’s important to acknowledge up front that this may not be a wise financial move for several reasons. Depending on the type of account you have, the rules may vary when it comes to withdrawals. When you withdraw funds early from an IRA, you will likely face taxes and/or penalties, which can add substantially to the cost of taking out that money.
With a traditional IRA, since you did not pay taxes on the money before you put it in, you have to pay income taxes when you take it out. In addition, if you're making that withdrawal before the age of 59½, you will owe a 10% tax penalty.
Withdrawing funds from an IRA before age of 59½ will result in a 10% penalty.
A Roth IRA allows you to withdraw funds tax-free, assuming the money has been there at least five years, because that contribution was made with after-tax dollars. However, you are limited to the amount you've actually contributed. Any part of the withdrawal that comes from investment earnings is subject to taxes if you take it out before the age of 59½. These early withdrawals are also subject to the 10% penalty.
Here's another consideration that you may need to consider. A significant early withdrawal of traditional IRA funds could bump you into a higher tax bracket. The same would apply to earnings from a Roth IRA, which would be taxed and considered income in the year in which it was withdrawn.
"Paying off credit card debt using your IRA jeopardizes your future retirement savings," says Carolyn Howard, founder of SeaCure Advisors LLC, in Sarasota, Fla. "It also causes you to pay more for the credit card debt due to the taxes on the IRA withdrawal."
Making the Withdrawal
Okay, so you understand you'll take a hit. If you wish to proceed, it’s important to follow a plan that minimizes collateral financial damage.
Start by listing all outstanding credit card debt, in order of annual percentage rate (APR), from highest to lowest. Decide how much of the total debt you want to pay off.
Next, check the IRA current balance. When calculating how much to withdraw, take into account any taxes and penalties, along with the amount of debt you wish to pay off. Remember that the rules for traditional and Roth accounts are different.
Calculate whether the total amount you wish to withdraw will put you in a higher tax bracket. If so, consider withdrawing over two tax years, paying off part of the debt one year and one the next.
"It's wise to be as tax-conscious as possible," says Carlos Dias Jr., founder and managing partner of Dias Wealth LLC in Lake Mary, Fla. "I always recommend running a projection report with an accountant or software (if you know what to do), potentially spreading the tax liability over several years."
Contact the financial institution that holds your IRA and ask for a distribution form. If you do not need to withdraw the full amount, make sure you're allowed partial withdrawals. When you submit the form, make sure you include all required documentation including how you wish to receive the funds, whether that's by check or direct deposit.
When You Get It
Once the funds are in your checking account, promptly pay off the credit cards you earmarked in order of highest APR. Remember, this isn't a windfall. Use the money for the intended purpose and for nothing else.
It may be tempting to scrape a little off the top for a big-ticket item you couldn't otherwise afford, or to use it for a quick, unexpected vacation. Don't do it. Leaving a balance on a credit card continues to add an expense until it is paid off.
Look for Exceptions
There are exceptions to the 10% early withdrawal penalty from an IRA including death, disability, and qualified education expenses.
A full list of exceptions appears on this IRS chart. One in particular, known as rule 72(t), allows penalty-free early withdrawals from an IRA, provided you make at least five substantially equal periodic payments (SEPPs) over your lifetime. Depending on the amount of credit card debt you wish to pay off, the time frame in which you want to make payments, and the amount you would receive via the application of rule 72(t), this may or may not help.
Even if you qualify for an exemption from the penalty, the regular income taxes on your withdrawal are still due.
Before making any withdrawals, make sure you consider other options for paying off your credit card debt.
One is going on a budget diet. This consists of taking a hard look at how much money comes in, how much goes out. You should also consider making cuts wherever possible. This means you may need to drop satellite or cable for over-the-air television, carpooling instead of driving to work, or borrowing books from the library instead of buying them from Amazon. Dig deep to find out how you can cut costs and create a pool of funds to dedicate to debt repayment.
There are different ways to attack your debt. A number of apps and online spreadsheets promote a variety of debt reduction strategies such as paying the cards with the highest interest rates first, or the debt snowball method. This strategy involves paying off the account with the lowest balance first, while making minimum payments on the rest. You will then use that money you save on the eliminated account to pay off the next lowest balance card, and so on, until your entire debt load is clear.
Regardless of what strategy you use, they involve applying the same amount of money to reduce debt each month—even after one account is paid off. You just apply bigger amounts to each remaining balance until all accounts are at zero.
Other methods for paying off debt include:
- Transferring balances to lower-interest credit cards.
- Taking out a personal loan.
- Borrowing from your 401(k).
- Filing for bankruptcy. In most cases, IRA accounts are protected during bankruptcy proceedings.
It’s important to examine other options to make sure the path you are on is the right one for you.
"Because credit card debt has such high interest rates, there are virtually no investments that will outperform it," says Cullen Breen, president of Dutch Asset Corporation in Albany, N.Y. "Because of this it can make sense to take the money from elsewhere."
The Finish Line
After all this, you've decided to make that withdrawal, you've prepared yourself for the implications, and you pay off your debt. Congratulations. But you're not out of the woods yet. Keep a handle on your spending and credit card use. If you don't, you may end up in the same position, and you can't rely on your IRA every time. After all, it's meant to be tucked away until you retire, and isn't a cash machine.
The Bottom Line
As good as it is to get out of debt, using IRA funds to do so comes at a cost, and not just the immediate ones of the taxes and penalties. You cannot effectively replace withdrawn funds since there are limits on the amount you can contribute to your IRA in any given year. If you are already putting in the full annual amount, you have no way to put in more, and so "make up" the amount you'll have lost in savings and interest.
"One of the benefits of a retirement account is the tax-deferred or tax-free growth of your principal. This means that more money is working for you to grow your retirement nest egg. If you remove part of your retirement savings, it will not only provide you with less retirement savings, but you will also have less money compounding for you over time," says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass.
Still, sometimes using an IRA to pay off consumer debt is the best available option. If it’s your best available option, make sure you are well-organized and prepared to avoid traps. Do all you can to minimize the cost to you and your finances, so that when it’s all over you can start afresh on the important tasks of living within your means and re-building your retirement nest egg.