Money Girl

Should I Use My IRA to Pay Off Credit Cards?

Episode Summary

969. Laura answers a listener's question about using an IRA to pay off credit card debt.

Episode Notes

969. Laura answers a listener's question about using an IRA to pay off credit card debt.

Find a transcript here.

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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 Sharon, who says:

“I’m 60 years old, single, and self-employed in real estate. I have over $750,000 in my IRA, which is invested in stock and bond mutual funds.

But I also have $60,000 in credit card debt that is weighing on me. The cards helped me stay afloat during a two-year downtime. Should I dip into my IRA to pay off my credit cards?”

Thanks for your question, Sharon! I know being self-employed can feel like a financial roller at times. Dealing with a two-year downturn in your business is tough, and using credit cards can be a lifeline in dire situations. The “weight” of this debt that you’re feeling is real, so I’m glad you reached out for help.

This post will review the pros and cons of tapping an individual retirement account or IRA before and after the official retirement age of 59.5. Plus, I’ll discuss other options for Sharon to pay off credit cards.

Welcome back to episode 969 of Money Girl–I appreciate you downloading the show! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, and founder of The Money Stack, a Substack newsletter.

You can learn more, ask any money question, and sign up for the Money Stack at LauraDAdams.com. You can get the newsletter for free or become a paid member with access to my live educational and Q&A events. Additionally, you can ask a money question by leaving a voicemail at 302-364-0308.

What are the traditional IRA withdrawal rules?

Before you or Sharon dip into your traditional IRA, it’s essential to 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.

Some examples of exceptions include:

Military: Certain distributions to qualified military reservists called to active duty are not subject to a 10% withdrawal penalty.
Homebuyer: If you're a qualified first-time homebuyer, you can withdraw up to $10,000, which isn’t subject to the 10% penalty.
Medical expenses: If you withdraw to pay unreimbursed medical expenses exceeding 7.5% of your adjusted gross income, they aren’t subject to the 10% penalty.
Medical premiums: If you're unemployed, you can make withdrawals to pay health insurance premiums without paying the 10% penalty.
Disaster recovery: If you have an economic loss due to a federally declared disaster where you live, up to $22,000 is not subject to the 10% penalty.
Domestic abuse victim: 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 is not subject to the 10% penalty.
Birth or adoption: Distributions up to $5,000 per child for qualified birth or adoption expenses are not subject to the 10% penalty.
Education: Distributions for higher education expenses for yourself or a dependent are not subject to the 10% penalty.
Emergency personal use: You can make one distribution per calendar year for personal or family emergency expenses up to $1,000, without being subject to the 10% penalty.
Tax Levy: If you must withdraw funds due to an IRS levy to satisfy a tax debt, they are not subject to the 10% penalty.
Health insurance: Distributions to pay for health insurance when you're unemployed for 12 weeks and receive unemployment compensation are not subject to the 10% penalty.
Disability: If you become permanently disabled, your distributions are not subject to the 10% penalty.
Death: If you die, neither your estate nor your account beneficiary is subject to the 10% penalty.

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

Since Sharon is 60, the good news is that a traditional IRA withdrawal is no longer "early" or subject to an additional 10% penalty. However, the consequence of tapping her traditional IRA would be paying income taxes on the distribution.

For example, let’s say Sharon earns $100,000 in her real estate business. If she also withdraws $60,000 from her traditional IRA, her taxable income for the year would be $160,000. That’s a substantial increase that she’d have to be prepared to pay.

Let’s assume she doesn’t have a tax-free source of income, like savings or investments in a brokerage account to sell. In that case, she’d actually have to withdraw much more from her IRA, perhaps $80,000 or $85,00, to cover the debt and taxes.

What are the Roth IRA withdrawal rules?

Sharon didn’t mention having a Roth IRA; however, I want to review its withdrawal rules. A Roth IRA is similar to a traditional IRA in many ways, except for how it's taxed.

With a Roth, you make after-tax, non-deductible contributions and can make tax-free withdrawals after age 59.5, if you’ve owned the account for at least five years.

However, regardless of your age, you can withdraw original Roth contributions without paying taxes or a penalty. But withdrawing untaxed earnings from a Roth does trigger income taxes plus a 10% early withdrawal penalty if you’re younger than 59.5.

Since Sharon is 60, taking a Roth IRA withdrawal would be tax-free, assuming she has owned it for at least five years. Going back to my example, if she earns $100,000 in real estate and withdraws $60,000 from a Roth IRA, Sharon’s taxable income for the year would be $100,000, not $160,000.

RELATED: Am I saving enough for retirement?

When to use retirement funds for debt

While I understand feeling anxious about debt, Sharon should only use her IRA as a last resort so it grows as large as possible before retirement. Her $750,000 nest egg could be her only source of lifetime income once she stops working. Every dollar you withdraw from a retirement account is a dollar plus potential growth that you won’t have to spend in the future.

Let’s say Sharon withdraws $85,000 from a traditional IRA to net approximately $60,000 after taxes. If the $85,000 were left invested at an average return of 7%, it could nearly double in ten years, growing to just under $170,000 by the time she’s 70. It could double again by her 80th birthday, growing to about $340,000. That’s the actual future cost of this withdrawal.

Another consideration is Sharon’s future income. If she taps her IRA and experiences another volatile period, she could end up back in debt with even less for retirement.

The other side of this dilemma is that Sharon’s credit cards are likely charging high interest rates, such as 20% or more. Paying off a debt with a 20% interest rate is a 20% guaranteed return on your money. Her IRA investments are likely earning much less and certainly don’t come with a guarantee.

Being debt-free could help Sharon feel less stressed, which has real value. We don’t know enough about her finances, career, and health to determine whether using her retirement to pay off credit cards is wise. Therefore, I’d recommend that she explore other options to pay off her cards first.

LISTEN ALSO: How to pay off credit cards when money is tight

6 ways to pay off credit card debt

Instead of tapping an IRA, here are six ways to pay off credit card debt that could make sense for you and Sharon:

Budgeting to cut unnecessary expenses radically for a period radically, so you have more money to send to credit cards. If Sharon is having a good year with more income, she should live on a bare-bones budget and send as much as possible to her cards.

If you haven't already scrutinized your expenses, there may be categories that you can reduce, giving you more financial breathing room. Alternatively, you may have options to increase your income with a higher-paying job, a second job, or a temporary or permanent side hustle.

Using a balance transfer credit card with a low or no-interest promotional period allows you to reduce or eliminate your interest expense temporarily. Even if Sharon could transfer $10,000 or $20,000 to a 0% card, the savings could help her. This strategy is most effective when you can pay off the balance interest-free before the promotion expires.
Getting a home equity line of credit (HELOC) may allow you to pay off higher-rate debt with a relatively low-interest loan or line of credit. Sharon didn’t mention being a homeowner, but if she has enough home equity, tapping into it could be less expensive than using an IRA. The downside is that you could face foreclosure if you're unable to pay a loan secured by your home.
Taking out a personal or debt consolidation loan with a relatively low interest rate, especially if you have good credit, may reduce your interest expense. The downside is that a short repayment term, such as three or five years, results in higher monthly payments that you must be able to afford.
Negotiating a debt settlement may be an option if you're about to miss a payment or are already behind. You can contact your card issuers to explain that you’ve experienced a hardship and negotiate a lower interest rate or a payment plan. It can negatively affect your credit, but it may be worthwhile if your credit scores have already declined.
Obtaining nonprofit credit counseling can include debt solutions offered at no cost or at a low price, such as a debt management plan (DMP). It consolidates debt into a single monthly payment, often with reduced interest rates and lower fees. Counseling services, such as those offered by Money Management International (MMI), can help you understand the pros and cons of various options.

Sharon might consider using a combination of these alternatives to pay off her credit cards. However, if Sharon still feels the pull to take an IRA withdrawal, perhaps she could withdraw a smaller amount, such as $20,000 or $30,000, and use her income to pay off the remaining debt balance. That would significantly reduce her tax liability.

Also, if Sharon’s income continues to be volatile, the timing of her IRA withdrawal matters. For instance, doing it in a low-income year means you may remain in a lower tax bracket. Taking a taxable withdrawal in a higher-income year is particularly problematic because it could push her into a higher tax bracket, resulting in unnecessary tax payments.

Sharon, thanks again for your question. If you’re proactive, you can absolutely take control of your debt. In future years, when your income rises, I recommend aggressively increasing your emergency savings and replenishing any IRA withdrawals to make up for lost time and money in your account.

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 upgrade to a paid membership, with access to my live educational and Q&A 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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