You have the impression that you are drowning in credit card debt. You can’t get any more money out of your salary, but you could have a nice amount stashed away in an IRA (IRA).Those monies are expected to remain undisturbed until you retire. But that’s a long time away.
Is it a better idea to spend all or portion of your IRA to get rid of such huge balances? Continue reading to learn more about the consequences of utilizing retirement assets to pay off credit card debt.
- Using your individual retirement account (IRA) to pay off credit card debt should not be your first choice.
- Withdrawals from a conventional IRA before the age of 5912 are taxed and subject to a 10% penalty.
- Early withdrawals from Roth IRAs are likewise penalized.
- Better options include shifting credit card balances to a lower-interest card or obtaining a debt consolidation loan.
Disadvantages of Paying Off Debt with an IRA
First and foremost, it is critical to recognize that this may not be a good financial choice for a variety of reasons. When you remove assets from an IRA early, you will almost certainly incur taxes and/or penalties, which may significantly increase the cost of debt repayment.
You must pay income taxes on any withdrawals from a regular IRA. Furthermore, if you withdraw before reaching the age of 5912, you will normally be subject to a 10% tax penalty. 1
A Roth IRA enables you to withdraw cash tax-free if they have been in the account for at least five years. However, any portion of the withdrawal derived from investment profits (rather than contributions) is taxed if taken before the age of 5912. The 10% penalty also applies to these early withdrawals.
The 10% early withdrawal penalty is waived in certain circumstances, including death, incapacity, and eligible school expenditures.
This Internal Revenue Service (IRS) graphic contains a complete list of exceptions. One in particular, known as rule 72(t), permits penalty-free early withdrawals from an IRA as long as you make at least five essentially equal monthly contributions during your lifetime. 1 This may or may not assist depending on the amount of debt you want to pay off, the time period in which you want to make payments, and the amount you would get under Rule 72(t).
Even if you qualify for a penalty exemption, you must still pay normal income taxes on your withdrawal.
“Using your IRA to pay off credit card debt jeopardizes your future retirement savings,” says Carolyn Howard, CEO of SeaCure Advisors LLC in Sarasota, Fla. “It also forces you to pay extra for credit card debt owing to IRA withdrawal taxes.”
Withdrawing monies from an IRA before the age of 5912 is usually subject to a 10% penalty.
Making the Withdrawal
So you realize you’ll have to pay taxes. If you must proceed, it is critical to devise a strategy that minimizes collateral financial harm.
Begin by listing all of your existing credit card debt, from greatest to lowest annual percentage rate (APR). Determine how much of your overall debt you want to pay off.
Check the current balance of your IRA. Consider any taxes and penalties, as well as the amount of debt you want to pay off, when determining how much to remove. Keep in mind that the requirements for regular and Roth IRAs vary.
Check to see whether the amount you want to remove is taxed at a higher marginal tax rate when combined with your other income. If this is the case, you may want to explore withdrawing funds across two tax years, paying off a portion of the debt one year and the remainder the following.
“It’s prudent to be as tax-aware as possible,” says Carlos Dias Jr., founder and managing partner of Dias Wealth LLC in Lake Mary, Florida. “I usually advocate preparing a projection report with an accountant or software (if you know what you’re doing) to stretch the tax obligation over many years.”
When you’re ready, call the financial institution or visit their website to start the transaction. If you don’t need to remove the whole balance in your account, be sure you may make partial withdrawals. Also, specify if you want the cash sent by cheque, direct deposit, or another method.
When You Get the Money
Once you have the finances, pay off the credit card debt as soon as possible. It may be tempting to scrape some of the top off for other uses, but don’t. Leaving a credit card debt adds further expenditure until it is paid off.
Better Ways to Pay Off Debt
Before making any withdrawals, be sure you’ve exhausted all other possibilities for repaying your credit card debt.
One is going on a diet on a budget. That entails taking a hard look at how much money comes in and how much goes out, then making cuts wherever possible, such as ditching satellite or cable for free over-the-air television, carpooling instead of driving to work, or borrowing books from the library rather than purchasing them on Amazon. Investigate ways to save money and set aside a certain amount of money for debt repayment.
There are several approaches to debt reduction. One approach is to pay off the cards with the highest interest rates first, a practice known as the debt avalanche method. Another strategy, known as the debt snowball method, is paying off the account with the lowest amount first. Each has its own set of financial and psychological benefits.
Other methods for paying off debt include:
- Transferring credit card balances to credit cards with cheaper interest rates.
- Obtaining a debt consolidation loan from a trustworthy bank or lender.
- Borrowing from your 401(k).
- Declaring bankruptcy. IRAs are usually protected during bankruptcy proceedings.
The Bottom Line
As beneficial as it is to pay off debt, utilizing your IRA to do so has a cost—and not just the obvious ones of taxes and penalties. Because there are restrictions on how much you may contribute to an IRA in any one year, you cannot effectively restore the withdrawn funds. If you’re already putting in the full yearly amount, there’s no way to contribute more and make up for missed savings and interest.
“One of the advantages of a retirement account is that your capital grows tax-deferred or tax-free.” This implies that more money is working for you to increase your retirement nest egg,” says Kirk Chisholm, investment manager of Innovative Advisory Group in Lexington, Massachusetts. “Removing a portion of your retirement savings will not only leave you with fewer retirement savings, but it will also leave you with less money compounding for you over time.”
Using an IRA to pay off consumer debt is sometimes the best—or only—option available. “There are basically no assets that can beat credit card debt because the interest rates are so high,” says Cullen Breen, president of Dutch Asset Corporation in Albany, N.Y. “As a result, it may make sense to take the money from somewhere else.”
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