Which is worse - less savings or more debt?
July 27, 2011 5:44 AM Subscribe
Should I cash out my IRA to significantly reduce my credit card debt?
I have approximately $4800 in an IRA that I contribute $100/month to via automatic withdrawal from my checking account. I set up the IRA a few years ago when I was running my own small business, so it is not tied to my current employer, nor do they contribute to it in any way.
A recent divorce has depleted my savings account to essentially zero, as well as contributed to nearly $7000 in credit card debt. My life has finally stabilized a bit and I am no longer using the cards, but I am having a hard time finding the cash to pay down the credit card balances as quickly as I'd like. This causes me a fair amount of stress.
I am considering cashing out the IRA and putting 100% of the money towards reducing the credit card debt. I know that I would personally feel much more comfortable with an empty IRA and significantly less credit card debt than I do with my current situation, but I admittedly don't know as much about these kinds of things as I should.
1. Is this a terrible idea? I know that common sense is to never dip into a retirement account, but I am in my late 20s and (foolishly?) feel like I have plenty of time to replenish the funds. Also, it seems like it will be more beneficial to me to no longer pay interest on such a high balance than it would to leave the IRA as is.
2. If I do withdraw the money, how much cash in hand am I realistically looking at getting back? I know there is a penalty for premature distribution, and that it will be taxed as well, but I'm unclear on whether or not the entire balance is taxed, or just any amount over my original contribution.
2b. The IRA is not tied to my employment and therefore my $100 monthly contribution has not been taken out of my paycheck pre-tax like many retirement account contributions are - how does this affect the tax question above, if at all?
3. Is there another option I haven't considered that would be a better choice for me? See below for the bigger picture re: my current financial situation.
Obviously, I will talk to the investment advisor who helped me set up the account initially if I do decide to move forward with this, but I'd like to get a feel for whether or not it is a smart choice for me before I get the ball rolling on anything.
Since I'm posting anon, some possibly relevant (and definitely tl;dr) information:
- I am in my late 20s and have steady employment with a very small non-profit (hence the equally small paychecks and barely-there raises). I don't anticipate my income increasing significantly in the next few years, nor my expenses decreasing (I live in an expensive part of the country and unfortunately my salary is not proportional to my cost of living).
- I still own a home in another state with my ex that is worth a decent amount more than we owe on it, but due to the housing market and our incomes, we are not currently able to sell, refinance, or take out a home equity line of credit (we bought the home in 2005, which was obviously an entirely different economic climate than today, and were approved for much more then than we'd get if we were mortgage shopping now).
- I have recently tried (and failed) to get a personal loan from a bank / credit union to pay off the credit card debt. Although I have slightly better than average credit, pay all my bills on time, and could afford the monthly payment -- since it would be a good deal less than the monthly payments to the credit card companies -- I do not qualify because they consider me fully responsible for the mortgage payment (of which I only pay a sliver; the ex takes care of the rest), as well as my own rent and personal monthly bills, and I get slapped with the good old 'excessive obligations' label.
Thanks in advance, MeFites!
I have approximately $4800 in an IRA that I contribute $100/month to via automatic withdrawal from my checking account. I set up the IRA a few years ago when I was running my own small business, so it is not tied to my current employer, nor do they contribute to it in any way.
A recent divorce has depleted my savings account to essentially zero, as well as contributed to nearly $7000 in credit card debt. My life has finally stabilized a bit and I am no longer using the cards, but I am having a hard time finding the cash to pay down the credit card balances as quickly as I'd like. This causes me a fair amount of stress.
I am considering cashing out the IRA and putting 100% of the money towards reducing the credit card debt. I know that I would personally feel much more comfortable with an empty IRA and significantly less credit card debt than I do with my current situation, but I admittedly don't know as much about these kinds of things as I should.
1. Is this a terrible idea? I know that common sense is to never dip into a retirement account, but I am in my late 20s and (foolishly?) feel like I have plenty of time to replenish the funds. Also, it seems like it will be more beneficial to me to no longer pay interest on such a high balance than it would to leave the IRA as is.
2. If I do withdraw the money, how much cash in hand am I realistically looking at getting back? I know there is a penalty for premature distribution, and that it will be taxed as well, but I'm unclear on whether or not the entire balance is taxed, or just any amount over my original contribution.
2b. The IRA is not tied to my employment and therefore my $100 monthly contribution has not been taken out of my paycheck pre-tax like many retirement account contributions are - how does this affect the tax question above, if at all?
3. Is there another option I haven't considered that would be a better choice for me? See below for the bigger picture re: my current financial situation.
Obviously, I will talk to the investment advisor who helped me set up the account initially if I do decide to move forward with this, but I'd like to get a feel for whether or not it is a smart choice for me before I get the ball rolling on anything.
Since I'm posting anon, some possibly relevant (and definitely tl;dr) information:
- I am in my late 20s and have steady employment with a very small non-profit (hence the equally small paychecks and barely-there raises). I don't anticipate my income increasing significantly in the next few years, nor my expenses decreasing (I live in an expensive part of the country and unfortunately my salary is not proportional to my cost of living).
- I still own a home in another state with my ex that is worth a decent amount more than we owe on it, but due to the housing market and our incomes, we are not currently able to sell, refinance, or take out a home equity line of credit (we bought the home in 2005, which was obviously an entirely different economic climate than today, and were approved for much more then than we'd get if we were mortgage shopping now).
- I have recently tried (and failed) to get a personal loan from a bank / credit union to pay off the credit card debt. Although I have slightly better than average credit, pay all my bills on time, and could afford the monthly payment -- since it would be a good deal less than the monthly payments to the credit card companies -- I do not qualify because they consider me fully responsible for the mortgage payment (of which I only pay a sliver; the ex takes care of the rest), as well as my own rent and personal monthly bills, and I get slapped with the good old 'excessive obligations' label.
Thanks in advance, MeFites!
Without knowing the rate, it's hard to answer. It would also be nice to know your current tax bracket since the $4,800 is going to be treated as income this year and could end up costing you on your taxes if it pushes you into another bracket. Maybe mail the mods with the info.
posted by yerfatma at 5:52 AM on July 27, 2011
posted by yerfatma at 5:52 AM on July 27, 2011
You'll have to pay a 10% early withdrawal penalty on the IRA, as well as income taxes on it. Re: 2b, you should have deducted the IRA contributions in the year you made them (line 32 on the 2010 1040)... file amended returns for those years if you did not. Whether this is optimal depends entirely on the interest rate you're being charged on the CC debt. If it's a very high rate, and the IRA withdrawal were my only option, I would probably do it.
Regarding other options, have you looking for a credit card with a promotional 0% interest rate on balance transfers? Typically, these promotional rates last for about a year, so it would buy you some time. You'd probably have to pay a one-time balance transfer fee of 2-3% of the balance.
posted by deadweightloss at 6:01 AM on July 27, 2011
Regarding other options, have you looking for a credit card with a promotional 0% interest rate on balance transfers? Typically, these promotional rates last for about a year, so it would buy you some time. You'd probably have to pay a one-time balance transfer fee of 2-3% of the balance.
posted by deadweightloss at 6:01 AM on July 27, 2011
Also, in the meantime, I would stop putting the $100/mo. towards the IRA, and start putting it towards the credit card debt.
posted by craven_morhead at 6:11 AM on July 27, 2011 [4 favorites]
posted by craven_morhead at 6:11 AM on July 27, 2011 [4 favorites]
OK, you are saying some confusing things in your post.
The IRA is not tied to my employment and therefore my $100 monthly contribution has not been taken out of my paycheck pre-tax like many retirement account contributions are
OK, so you have a regular IRA (not a Roth IRA) and you've been contributing to it on your own. Have you or have you not been claiming the IRA on your taxes? I'm not sure why you would NOT claim the IRA contributions on your taxes, but I have no idea what the implication is if you have NOT done so. When I worked in this area, anytime someone made a distribution from a tax-advantaged account, we were required to behave as if the money was tax-advantaged (ie, take the penalty and if requested, withholding for taxes). The entire amount is taxed when you make a withdrawal from a traditional IRA.
However, all this being said: If the amount you would be charged in taxes and fees is MORE than you will pay in interest over the life of paying off your credit card debt, then it's not worth it, especially given that it's your retirement savings.
If, on the other hand, it is ultimately cheaper to pay the taxes and the penalties NOW to retire ~$4800 in debt, then go ahead. Go with whatever is cheaper.
posted by Medieval Maven at 6:11 AM on July 27, 2011 [1 favorite]
The IRA is not tied to my employment and therefore my $100 monthly contribution has not been taken out of my paycheck pre-tax like many retirement account contributions are
OK, so you have a regular IRA (not a Roth IRA) and you've been contributing to it on your own. Have you or have you not been claiming the IRA on your taxes? I'm not sure why you would NOT claim the IRA contributions on your taxes, but I have no idea what the implication is if you have NOT done so. When I worked in this area, anytime someone made a distribution from a tax-advantaged account, we were required to behave as if the money was tax-advantaged (ie, take the penalty and if requested, withholding for taxes). The entire amount is taxed when you make a withdrawal from a traditional IRA.
Withdrawals from your Traditional IRA will be treated as ordinary income, and if you are under age 59.5 when the distribution occurs, the amount will be subject to an early-withdrawal penalty of 10% (of the amount withdrawn). The amount will be exempted from the early-withdrawal penalty if you meet one of the following exceptions:If this is a Roth IRA, you've got another ball of wax (Roth IRA - pay taxes now so you don't pay them later).
-You plan to use the distribution towards the purchase or rebuilding of a first home for yourself or a qualified family member (limited to $10,000 per lifetime).
-You become disabled before the distribution occurs.
-Your beneficiary receives the assets after your death.
-You use the assets for medical expenses for which you were not reimbursed.*
-Your distribution is part of a SEPP program.
-You use the assets for higher-education expenses.*
-You use the assets to pay for medical insurance after you lose your job.*
-The assets are distributed as a result of an IRS levy.
-The amount distributed is a return on non-deductible contributions.
* Limitations apply
However, all this being said: If the amount you would be charged in taxes and fees is MORE than you will pay in interest over the life of paying off your credit card debt, then it's not worth it, especially given that it's your retirement savings.
If, on the other hand, it is ultimately cheaper to pay the taxes and the penalties NOW to retire ~$4800 in debt, then go ahead. Go with whatever is cheaper.
posted by Medieval Maven at 6:11 AM on July 27, 2011 [1 favorite]
The money in your IRA is, by definition, pre-tax, unless it is a Roth IRA. Pre-tax doesn't necessarily mean payroll withholdng, it just means that your IRA contributions come off your income before the IRS calculates your tax. If you did not deduct your contributions in the year(s) you made them, file an amended return for those year(s) and you'll get a refund.
You will have to pay income tax, plus the 10% penalty, for all early distributions from your IRA except for certain purposes (the big ones are your first home purchase, college, and medical expenses). The reason for this is that you have never paid income tax on any of these funds.
I would agree with others that reducing your rate through a balance transfer offer is worth investigating. I have recently received offers from Citi offering a teaser 0% rate for 18 months, which is outstanding. I would find and apply for as many such offers as you can, all at once (so they don't start showing up on your credit report until each has already been approved or denied).
posted by kindall at 6:49 AM on July 27, 2011
You will have to pay income tax, plus the 10% penalty, for all early distributions from your IRA except for certain purposes (the big ones are your first home purchase, college, and medical expenses). The reason for this is that you have never paid income tax on any of these funds.
I would agree with others that reducing your rate through a balance transfer offer is worth investigating. I have recently received offers from Citi offering a teaser 0% rate for 18 months, which is outstanding. I would find and apply for as many such offers as you can, all at once (so they don't start showing up on your credit report until each has already been approved or denied).
posted by kindall at 6:49 AM on July 27, 2011
There are some contradictory statements in your question that are confusing. You say you have trouble coming up with money to pay down your credit card bills, but you contribute $100 to your IRA account every month. You say you own a house that is worth quite a bit more than you owe--which means you have lots of equity--but you can't get a HELOC. That doesn't make any sense at all, unless you've misstated or misunderstood the circumstances of your home value.
I would sit down with a licensed financial adviser before I made any decisions re: cashing out the IRA. Also, you can try contacting your local Consumer Credit Counseling Service outfit--they usually give free or inexpensive counseling on managing credit card debt.
Here's an article from Clark Howard's website about the consequences of early 401(k)/IRA withdrawals.
posted by litnerd at 6:53 AM on July 27, 2011
I would sit down with a licensed financial adviser before I made any decisions re: cashing out the IRA. Also, you can try contacting your local Consumer Credit Counseling Service outfit--they usually give free or inexpensive counseling on managing credit card debt.
Here's an article from Clark Howard's website about the consequences of early 401(k)/IRA withdrawals.
posted by litnerd at 6:53 AM on July 27, 2011
yerfatma: "It would also be nice to know your current tax bracket since the $4,800 is going to be treated as income this year and could end up costing you on your taxes if it pushes you into another bracket. "
That's not how taxation in the US works. If you veer into the other bracket, you only pay the higher rate on any income you make above the bracket.
Suppose the tax brackets are:
Up to $100: 5%
$100 to $200: 10%
$200 to $300: 15%
Now, suppose you made $201 last year. You'd pay $5 in taxes on your first $100 of income, $10 on the next $100, and 15 cents on the last dollar, for a total of $15.15 in tax.
Sure, this affects your calculations, and there's a chance you'll jump over the $34,500 bracket (where the rate jumps from 10% to 25%). However, a large chunk of your income will not suddenly vanish if you jump over the bracket (you will begin to see diminishing returns though).
Granted, nobody seems to realize that taxes work this way, even when taxation is literally front-page news.
Oh, and you're renting that house, right???
posted by schmod at 7:09 AM on July 27, 2011 [3 favorites]
That's not how taxation in the US works. If you veer into the other bracket, you only pay the higher rate on any income you make above the bracket.
Suppose the tax brackets are:
Up to $100: 5%
$100 to $200: 10%
$200 to $300: 15%
Now, suppose you made $201 last year. You'd pay $5 in taxes on your first $100 of income, $10 on the next $100, and 15 cents on the last dollar, for a total of $15.15 in tax.
Sure, this affects your calculations, and there's a chance you'll jump over the $34,500 bracket (where the rate jumps from 10% to 25%). However, a large chunk of your income will not suddenly vanish if you jump over the bracket (you will begin to see diminishing returns though).
Granted, nobody seems to realize that taxes work this way, even when taxation is literally front-page news.
Oh, and you're renting that house, right???
posted by schmod at 7:09 AM on July 27, 2011 [3 favorites]
Oh, and here's a 2011 Federal Tax Bracket Calculator.
Remember that you're only counting taxable income here, so remember to subtract health benefits, pretax 401k contributions, and local taxes.
You then need to make the same calculations for your local/state income taxes. Those brackets are going to be different.
posted by schmod at 7:16 AM on July 27, 2011
Remember that you're only counting taxable income here, so remember to subtract health benefits, pretax 401k contributions, and local taxes.
You then need to make the same calculations for your local/state income taxes. Those brackets are going to be different.
posted by schmod at 7:16 AM on July 27, 2011
If you take money out, you pay the tax, plus a penalty. ouch. I'd consider stopping the contribution, putting that money onto the card debt, and doing some serious budgeting to find some money to pay down the debt. Also, call the credit card company and negotiate the rate, even getting a better card, possibly from the credit union, with a better rate.
posted by theora55 at 8:01 AM on July 27, 2011
posted by theora55 at 8:01 AM on July 27, 2011
1. Is this a terrible idea? I know that common sense is to never dip into a retirement account, but I am in my late 20s and (foolishly?) feel like I have plenty of time to replenish the funds. Also, it seems like it will be more beneficial to me to no longer pay interest on such a high balance than it would to leave the IRA as is.
From a long-term financial point of view, paying off credit cards is almost never a bad idea. They usually charge very high interest rates compared to other types of loans (and are not tax deductible unlike some other types of loans), plus those interest rates are usually higher than the rates of return you could reasonably expect from investments like the ones in your IRA. From a short-term financial point of view, paying off debt can sometimes be risky if you don't have a lot of savings, because if a more serious unexpected need for money comes up your lack of debt probably won't help as much as having liquid assets. And from a psychological point of view it could go either way, it feels good to get rid of debt that's hanging over you, but keeping money in a retirement fund and never taking it out under any circumstances is a nice ideal to try to stick with. Overall it's definitely not a terrible idea, and depending on your particular situation and mindset it could be your best option.
2. If I do withdraw the money, how much cash in hand am I realistically looking at getting back? I know there is a penalty for premature distribution, and that it will be taxed as well, but I'm unclear on whether or not the entire balance is taxed, or just any amount over my original contribution.
If it's a Traditional IRA (which is not really clear from your question) then you have to pay taxes on the entire amount (since it has never been taxed at this point) and on top of that you have to pay a 10% early withdrawal penalty on the full amount. If it's a Roth IRA, you can withdraw all of your contributions with no taxes or penalties (so if you put in $100/month for 2 years you could take out $2400) but if you take out the earnings (if any) the earnings would be taxed and penalized similar to the Traditional IRA.
2b. The IRA is not tied to my employment and therefore my $100 monthly contribution has not been taken out of my paycheck pre-tax like many retirement account contributions are - how does this affect the tax question above, if at all?
If it's a Traditional IRA, then you have been doing it wrong. You seem to have been accidentally paying taxes on your contributions even though you shouldn't have. If it's a Roth IRA, then you have been correctly paying taxes on the contributions so that they don't have to be taxed when you eventually take the money out. It doesn't affect the questions above other than that you may have filled your taxes out incorrectly and may be eligible for a refund of some amount.
3. Is there another option I haven't considered that would be a better choice for me? See below for the bigger picture re: my current financial situation.
As others have said, consider temporarily stopping your retirement contributions until the debt is paid off. Also obviously pay as much into the debt as possible from your normal income, although I assume you are already doing that.
posted by burnmp3s at 8:31 AM on July 27, 2011
From a long-term financial point of view, paying off credit cards is almost never a bad idea. They usually charge very high interest rates compared to other types of loans (and are not tax deductible unlike some other types of loans), plus those interest rates are usually higher than the rates of return you could reasonably expect from investments like the ones in your IRA. From a short-term financial point of view, paying off debt can sometimes be risky if you don't have a lot of savings, because if a more serious unexpected need for money comes up your lack of debt probably won't help as much as having liquid assets. And from a psychological point of view it could go either way, it feels good to get rid of debt that's hanging over you, but keeping money in a retirement fund and never taking it out under any circumstances is a nice ideal to try to stick with. Overall it's definitely not a terrible idea, and depending on your particular situation and mindset it could be your best option.
2. If I do withdraw the money, how much cash in hand am I realistically looking at getting back? I know there is a penalty for premature distribution, and that it will be taxed as well, but I'm unclear on whether or not the entire balance is taxed, or just any amount over my original contribution.
If it's a Traditional IRA (which is not really clear from your question) then you have to pay taxes on the entire amount (since it has never been taxed at this point) and on top of that you have to pay a 10% early withdrawal penalty on the full amount. If it's a Roth IRA, you can withdraw all of your contributions with no taxes or penalties (so if you put in $100/month for 2 years you could take out $2400) but if you take out the earnings (if any) the earnings would be taxed and penalized similar to the Traditional IRA.
2b. The IRA is not tied to my employment and therefore my $100 monthly contribution has not been taken out of my paycheck pre-tax like many retirement account contributions are - how does this affect the tax question above, if at all?
If it's a Traditional IRA, then you have been doing it wrong. You seem to have been accidentally paying taxes on your contributions even though you shouldn't have. If it's a Roth IRA, then you have been correctly paying taxes on the contributions so that they don't have to be taxed when you eventually take the money out. It doesn't affect the questions above other than that you may have filled your taxes out incorrectly and may be eligible for a refund of some amount.
3. Is there another option I haven't considered that would be a better choice for me? See below for the bigger picture re: my current financial situation.
As others have said, consider temporarily stopping your retirement contributions until the debt is paid off. Also obviously pay as much into the debt as possible from your normal income, although I assume you are already doing that.
posted by burnmp3s at 8:31 AM on July 27, 2011
I am a disciple of Suze Orman who says that you should never take out of retirement to pay off credit cards - they can't touch your retirement in bankruptcy so it should be secure there. Nthing stopping additional contributions. An organization like CCCS (who I successfully used to get out of way more than $7k debt) can help make your debt repayments manageable.
posted by getawaysticks at 9:53 AM on July 28, 2011
posted by getawaysticks at 9:53 AM on July 28, 2011
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posted by Perplexity at 5:46 AM on July 27, 2011 [1 favorite]