You feel like you're drowning in credit card debt. And while you can't squeeze anything more out of your paycheck, you may have a tidy sum sitting in an 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 your IRA to get those high balances off your back? Read on to find out more about the implications of using retirement funds to pay off credit card debt.
- Withdrawing funds from your IRA to pay credit card debt shouldn't be your first option.
- Any withdrawals from a traditional IRA before the age of 59½ are subject to taxes and a 10% penalty.
- Roth IRAs also penalize early withdrawals.
- There are better alternatives, such as transferring credit card balances to a lower-interest card or taking out a debt consolidation loan.
Disadvantages of Paying off Debt With an IRA
First of all, it’s important to acknowledge upfront that this may not be a wise financial move, for several reasons. When you withdraw funds early from an IRA, you will likely face taxes and/or penalties, which can add substantially to the cost of paying off your debt.
With a traditional IRA, you have to pay income taxes on any money you take out. In addition, if you're making that withdrawal before you've reached the age of 59½, you will generally owe a 10% tax penalty.
A Roth IRA allows you to withdraw funds tax-free, assuming the money has been there for at least five years. However, any part of the withdrawal that comes from investment earnings (as opposed to your contributions) is subject to taxes if you take it out before age 59½. These early withdrawals are also subject to the 10% penalty.
There are exceptions to the 10% early withdrawal penalty, 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 take at least five substantially equal periodic payments over your lifetime. Depending on the amount of 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.
"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."
Withdrawing funds from an IRA before age of 59½ will generally result in a 10% penalty.
Making the Withdrawal
Okay, so you understand you'll take a tax hit. If you wish to go ahead anyway, it’s important to follow a plan that minimizes collateral financial damage.
Start by listing all your 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 your IRA's current balance. When calculating how much to withdraw, take into account any taxes and penalties, along with the amount of debt you plan to pay off. Remember that the rules for traditional and Roth accounts are different.
Check whether the amount you wish to withdraw will be taxed at a higher marginal tax rate, when added to your other income. If so, you might want to consider withdrawing over two tax years, paying off part of the debt one year and the rest 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."
When you're ready to proceed, contact the financial institution by phone or go on its website to initiate the transaction. If you don't need to withdraw the full amount in your account, make sure you're allowed partial withdrawals. Also indicate how you wish to receive the funds, whether that's by check, direct deposit, or some other means.
When You Get the Money
Once the funds are in your hands, promptly pay off the credit card debt. While it may be tempting to scrape a little off the top for other purposes, don't do it. Leaving a balance on a credit card continues to add an expense until it is paid off.
Better Ways to Pay off Debt
Before taking any withdrawals, be sure you've considered any other options for paying off your credit card debt.
One is going on a budget diet. That means taking a hard look at how much money comes in and how much goes out, then making cuts wherever possible—such as dropping 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. One strategy is to pay off the cards with the highest interest rates first, sometimes called the debt avalanche method. Another, the debt snowball method, involves paying off the account with the smallest balance first. Each has its own financial and psychological advantages.
Other methods for paying off debt include:
- Transferring your credit card balances to lower-interest credit cards.
- Taking out a debt consolidation loan from a bank or other reputable lender.
- Borrowing from your 401(k).
- Filing for bankruptcy. In most cases, IRA accounts are protected during bankruptcy proceedings.
The Bottom Line
As good as it is to get out of debt, using your IRA to do so comes at a cost, and not just the immediate ones of taxes and penalties. You cannot effectively replace the withdrawn funds since there are limits on how much 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 add more and make up for whatever you've 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," notes Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass. "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."
Still, sometimes using an IRA to pay off consumer debt is the best, or only, available option. "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."