Lesser of two tax burdens?

December 13, 2008 3:40 PM

My partner and I need to pay off some debt, and unfortunately we need to dip into our retirement funds. Our tax accountant is on vacation and we can't find the answer to our question. We have two sources–either sell some stock or cash out a couple of short-term IRA CDs. Which is the lesser of two evils?

The service charge on either transaction would be about the same (~$50). We understand that the painful part would come in the form of the taxes on the amount we receive. Is there a difference in how the two types of transactions would be taxed? If we took a theoretical amount of $10k from either transaction, which would be taxed at a higher rate? What is the tax rate on either of these. I'm in California, and we'd need to do this before the end of 2008. If it matters, the money would go directly to pay off credit cards, car, student loans.

And it always makes sense to pay off debt before saving for retirement, right? (Higher interest rate on debt than retirement fund, blah blah). Oh, and we're living paycheck to paycheck.

Thanks in advance!

posted by al_fresco to work & money (11 comments total)

You'll need to know the cost basis of the stock you want to sell and also if you've been holding it for more than or less than a year (which distinguishes between long-term gains and short-term gains). Without that info we can't really help much.
posted by Durin's Bane at 4:19 PM on December 13, 2008

Are you sure you can't (1) get the debt stalled for a couple of weeks, (2) sell some stuff, (3) cut way back to make up for what selling stuff won't cover?
posted by Lesser Shrew at 4:29 PM on December 13, 2008

Something to consider is that early withdrawl from an IRA is generally subject to a 10% tax penalty (above and beyond any taxes otherwise due) unless you meet one of the exceptions.
posted by RichardP at 5:04 PM on December 13, 2008

And it always makes sense to pay off debt before saving for retirement, right? (Higher interest rate on debt than retirement fund, blah blah).

No, it doesn't always make sense. It may or may not make sense for you in this case, but it is far from a rule. And your "higher interest rate on debt than retirement" statement doesn't really make much sense as a way for you to decide, for a few reasons-- 1) you don't typically get an "interest rate" for retirement savings, you get returns [unless you have your money in something like a CD, like you do, which is generally considered way too conservative an investment for your retirement fund unless you're within a decade or so of retirement age]; 2) you can't compare the "interest rate" 1-to-1 because retirement savings accounts give you a big tax benefit (plus you may be losing a tax deduction on the student loan interest payments); and 3) in your case if you're paying penalties to remove money from the retirement account, it throws the calculations off even further.

Anyway, we need more details to help with your question-- what Durin's Bane said, plus your income bracket, and whether the IRA is a regular IRA or a Roth IRA, and whether the stocks are in a 401(k) or an IRA, etc-- it's hard to answer the question without numbers.

Also, if the stocks are in a 401(k), have you looked into getting a loan from your 401(k) rather than taking the money out entirely?
posted by EmilyClimbs at 6:08 PM on December 13, 2008

I thought that you could take money out of an IRA -- not the interest accrued, but the principal investment -- and not pay additional taxes on it because those funds were already taxed from your income. Is that only a Roth IRA? I'd like to know the answer to this question too.
posted by theantikitty at 7:28 PM on December 13, 2008

And it always makes sense to pay off debt before saving for retirement, right? (Higher interest rate on debt than retirement fund, blah blah).

Even if it were true that paying off debt should come before saving for retirement, that would not necessarily make it prudent to dip into existing retirement savings to pay off debt. Factors to consider include the tax consequences of the withdrawal; the original, current, and estimated future value of the retirement assets; what sort of debt you have and how it is held; and many other factors. If at all possible, you should talk to a professional about your particular situation before making this move.

This is an especially bad time to be selling stock, as it's likely worth substantially less now than when you bought it, so you'll have bought high and sold low. The overwhelming majority of experts predict that stock prices will rebound, and many are advising buying now while prices are low to take advantage of the market.
posted by decathecting at 7:56 PM on December 13, 2008

"Is that only a Roth IRA? " Sort of.
posted by gjc at 8:25 PM on December 13, 2008

Why do you need to do this before the end of 2008?

There are a variety of debt payoff strategies. A popular one is the debt snowball. If you're having trouble meeting minimum payments, you should probably go to a certified consumer credit counseling service. They can help you put together a payoff plan and in some cases enter into a debt management plan, in which your creditors tend to offer lower interest rates in the expectation of a longer, but 100%, payoff.

These are all vastly superior to the alternatives you present. Save those for OMGZ emergency situations.
posted by dhartung at 10:11 PM on December 13, 2008

And it always makes sense to pay off debt before saving for retirement, right?

No, really it doesn't. It's not all about return. For instance, you have gotten yourself into debt and are living from paycheck to paycheck. That suggests that if one thing goes wrong - one of you gets a serious illness, for example, and can't work for a while - you're going to have to declare bankruptcy. If you declare bankruptcy, your retirement assets are protected from seizure by your creditors. In that case, would you prefer to have gutted your retirement accounts first, or not? It really is that simple.

Now, it doesn't matter what kind of asset you liquidate to make a (traditional, non-Roth) IRA withdrawal - it's going to be taxed as 2008 income on your Federal and State income tax returns. You'll have what's left over to pay debt. The money that goes to Uncle Sam does not go to pay down debt and does not continue its tax-deferred growth that it was previously enjoying, either; it just disappears.

If you have a Roth IRA, you can withdraw principal contributions without any penalty and use them for whatever purpose you like. That is certainly the least of evils in this case. You cannot withdraw interest or appreciation amounts from a Roth IRA without paying a penalty, though; I believe it is 10%, but I could be wrong.

Finally, liquidating stock in an IRA at a loss is really one of the worst things you can do if you don't have to do it, because you don't gain any tax benefit from realizing the loss. If that sentence doesn't make sense to you, perhaps a financial planner would be of benefit here.
posted by ikkyu2 at 12:30 AM on December 14, 2008

liquidating stock in an IRA at a loss is really one of the worst things you can do if you don't have to do it, because you don't gain any tax benefit from realizing the loss.

The fact that you can't deduct a loss in your IRA has no bearing on whether you should cash in the CDs or the stock. The decision should be based on which you want to hold in your IRA in the future. Whether or not your stocks have a loss from the past is irrelevant.
posted by JackFlash at 1:25 PM on December 14, 2008

Thanks for all of the thoughtful answers. It does seem like it makes sense to speak with someone about our choices. I guess we'll look around. The last person I spoke with was not interested in working with someone with so few assets to work with, and I guess I just assumed that financial planners only wanted to work with folks that have that are better off than we are.

Both the IRA and the stocks are, in essence, gifts (another story), so incurring losses on either is kind of theoretical. We had just hoped to minimize our tax burden in the present and maximize what we can use to pay down our debt and what we might have left over for retirement.

Thanks again. You've given us plenty to think about. Happy holidays, everyone!
posted by al_fresco at 10:15 PM on December 18, 2008