Money Girl

Should I Take an IRA Withdrawal to Pay Off My Car?

Episode Summary

Laura answers a listener’s question and reviews the rules and updated penalty exceptions for traditional IRA withdrawals.

Episode Notes

Laura answers a listener’s question and reviews the rules and updated penalty exceptions for traditional IRA withdrawals.

Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.

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Episode Transcription

Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Helene G., who says:

"I love your podcast and always learn so much from you. I'm 60 and got laid off multiple times, leaving me with severe work-related anxiety. I mostly live on a severance but also have a dream job working at a garden center. It pays a third of my previous salary but has about one percent of the stress.

I sold my home and built a little apartment in my best friend's basement, reducing my basic monthly expenses to less than $1,000. My only debt is a car loan balance of $3,700 at 2.79% interest. My income covers my costs and allows me to save for retirement. I have a traditional IRA that I hope not to need for many years.

Should I withdraw $3,700 from my IRA to pay off my car and be debt-free? My quarterly statement shows an average return of about 3.5%. I also have high-interest savings of several months' expenses that I can use to pay off the car.

If you were me, with an anxious personality, would you take an IRA withdrawal to pay off the car for more peace of mind?"

Thanks so much for your question and kind words, Helene! I'm glad you've successfully reduced your expenses for a lower-stress lifestyle.

This post will answer Helene's question and review the rules and updated penalty exceptions for taking IRA withdrawals.

Welcome back, everyone, and thanks for joining me on episode 877! I'm Laura Adams, an award-winning author, female finance spokesperson, money speaker, founder of The Money Stack, a Substack newsletter, and host of the Money Girl podcast with over 43 million downloads.

If you're getting value from the free content we love creating, subscribe and consider submitting a 5-star rating or review on your podcast app of choice! If you have a question about money for the show, leave it on our voicemail at 302-364-0308. You can also send an email and sign up for the free Money Stack newsletter at LauraDAdams.com.

What are the traditional IRA withdrawal rules?

Before you or Helene dip into your IRA, understand the withdrawal rules. In general, a withdrawal before age 59.5 is considered an early distribution. That means any amount not previously taxed would be subject to income taxes plus an additional 10% penalty unless an exception applies.

Since Helene is 60, an IRA withdrawal is no longer "early" or subject to an additional 10% penalty. The only tax consequence of tapping her traditional IRA would be paying income taxes on the distribution.

What are traditional IRA early withdrawal exceptions?

If you're younger than 59.5, there are exceptions when you avoid the 10% penalty, but not income taxes, on a traditional IRA withdrawal. The IRS lists the following 17 penalty exceptions for IRAs, with some that began in 2024.

Age: As I mentioned, after you reach age 59.5, you no longer must pay a 10% withdrawal penalty, no matter why you take traditional IRA distributions.
Birth or adoption: Distributions up to $5,000 per child for qualified birth or adoption expenses won't be subject to the 10% withdrawal penalty.
Death: If you die, neither your estate nor your account beneficiary is subject to the 10% withdrawal penalty.
Disability: If you become permanently disabled, your distributions are not subject to the 10% withdrawal penalty.
Disaster recovery distribution: If you have an economic loss due to a federally declared disaster where you live, up to $22,000 won't be subject to the 10% withdrawal penalty.
Domestic abuse victim distribution: If you're the victim of domestic abuse by a spouse or domestic partner, up to the lesser of $10,000 or 50% of your account won't be subject to the 10% withdrawal penalty.
Education: Distributions are not subject to the 10% withdrawal penalty if you use them to pay qualified higher education expenses.
Emergency personal expense: You can make one distribution per calendar year for personal or family emergency expenses up to $1,000, which won't be subject to the 10% withdrawal penalty.
Equal payments: If you create a 72(t) plan, a series of substantially equal payments, those distributions are not subject to the 10% withdrawal penalty.
Homebuying: If you're a qualified first-time homebuyer, which includes previous homeowners who haven't owned a primary residence in the past three years, you can withdraw up to $10,000, which won't be subject to the 10% penalty.
Levy: If you must withdraw funds due to an IRS levy to satisfy a tax debt, those distributions are not subject to the 10% withdrawal penalty.
Medical expenses: If you withdraw to pay unreimbursed medical expenses exceeding 7.5% of your adjusted gross income, they won't be subject to the 10% withdrawal penalty.
Medical premiums: If you're unemployed, you can make withdrawals to pay health insurance premiums without paying the 10% penalty.
Military: Certain distributions to qualified military reservists called to active duty won't be subject to the 10% withdrawal penalty.
Returned IRA contributions: If you decide to reverse IRA contributions by your tax filing due date or any extensions, your earnings would be taxable, but the withdrawal would not be subject to the 10% penalty.
Rollovers: Eligible distributions you contribute to another retirement plan within 60 days won't be subject to the 10% withdrawal penalty.
Unemployed health insurance: Distributions to pay for health insurance if you're unemployed for 12 weeks and received unemployment compensation in the year of the distribution or the subsequent year won't be subject to the 10% withdrawal penalty.

Note that these penalty exceptions apply to IRAs, not workplace retirement plans, like a 401(k) or 403(b), which have different withdrawal rules.

LISTEN ALSO: 6 required minimum distribution (RMDs) retirement rules you should know

Should I take a traditional IRA withdrawal?

I generally don't recommend tapping a traditional IRA early; however, if you qualify for one of the penalty exceptions, it costs less. And as mentioned, Helene's age would make her withdrawal a penalty exception.

You eventually must pay income taxes on traditional IRA balances that weren't previously taxed. So, one consideration should be how a traditional IRA withdrawal would affect your taxes.

Helene mentioned earning about one-third of her previous salary before getting laid off. Adding a few thousand to her annual income wouldn't have a substantial negative impact on her taxes. But she would need to have enough savings to pay the tax liability.

However, since Helene said she could cover her living expenses and still invest for retirement, I recommend not raiding her IRA to pay off her car loan. Keeping her IRA balance intact allows it to grow, which could be worth much more to her in the long run.

While I understand feeling anxious about debt, $3,700 is a relatively small amount with a meager interest rate. If Helene temporarily pauses her retirement contributions or reduces them, she could send more to her auto loan monthly and eliminate it faster.

Helene mentioned having high-yield savings worth a few months' living expenses she could use to pay off the loan ahead of schedule. She didn't mention the interest rate, but I got the impression it may be higher than her IRA earnings, which she said was a 3.5% return.

That concerns me because we've had a terrific year in the markets. As of November 4, 2024, the S&P 500 has increased by over 20%, with 47 new all-time highs in 2024.

So, I'd recommend Helene get professional help reviewing how her IRA is invested.

Owning a diversified index fund would have yielded her much more than 3.5%.

Helene, if you're ready to get rid of your low-rate auto loan, I recommend paying a little extra each month but not tapping your savings or IRA, especially since the loan only charges you 2.79%, which is extremely low.

You might need your savings for an emergency and regret having used it to pay off your car early. Your IRA should only be used as a last resort so it grows as large as possible before you need it for income.

As you approach retirement, be sure to meet with a qualified financial advisor who can help you maximize your investments while considering your risk tolerance and goals.

Before we go, here's a quick reminder to subscribe to The Money Stack, my weekly newsletter, when you visit LauraDAdams.com. It's filled with money tips, tools, news, challenges, and things I enjoy! You can subscribe for free or become a paid member with access to live educational events.

That's all for now. I'll talk to you soon. Until then, here's to living a richer life!

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