Should You Take Money from Your IRA to Pay Off Debt?

May 05, 2023 by First Federal Bank

IRA-2As you near your target retirement age, you’ll want to reduce your existing debt to give yourself financial freedom. This includes paying off your credit card balances, student loan debt, car loans, and your mortgage. If you’ve grown a hearty IRA, you’ll wonder if you can use those retirement funds early to knock out your debt. Is that a wise way to tackle your debt?

Withdrawing IRA funds before retirement

An Individual Retirement Account is a fantastic way to build wealth for your future. Most people build an IRA with the intent of living off the distributions once they quit working a full-time job.

Technically, you can take back this money for other uses, but here’s the biggest factor to consider: If you’re below 59.5 years old, you’ll be saddled with a 10% tax penalty for early withdrawal from your IRA.

CNN Money points out that, additionally, “the IRA withdrawal would be taxed as regular income, and could possibly propel you into a higher tax bracket, costing you even more.”

Are there exceptions to the penalty?

There are certain major life events that can allow you to withdraw money from your IRA early while avoiding the penalty fee (though any normal income taxes would still apply). According to the IRS, these include a death, becoming permanently disabled, active military duty, permitted medical or higher education expenses, and some other uncommon situations.

Long-term consequences of early withdrawal

Debt payoff may seem like a good use of IRA funds now, but it can jeopardize your retirement savings and put you in a worse financial state later.

You need to let the funds grow over time, and reducing the balance now could seriously impair your savings potential in the future. “Money you take out of an IRA cannot be replaced, since you would still be restricted to yearly contribution limits for future contributions,” cautions CNN Money. Even withdrawing a small amount of money now could compound into a greater loss over a few decades.

When is it wise to withdraw from your IRA early?

Is it ever a good idea to take the 10% hit to your withdrawal? Some financial experts say you should only do so as a last resort for avoiding bankruptcy or foreclosure.

However, AARP contributor Lynnette Khalfani-Cox, known as The Money Coach®, recommends you should decide whether to take money from your IRA based on the interest rate you’re paying on your outstanding debt. For instance, if you have credit card debt at a 15 percent annual interest rate, that will lose you more money over time than from the 10% penalty that an early IRA withdrawal would incur.

Wisely using your retirement savings

If you decide to tap into your retirement savings, take out a loan from your 401(k), since — as the Investopedia staff point out — IRAs do not allow account owners to borrow funds. A loan typically has a low interest rate, and you can access the money with less penalty as a loan rather than a permanent distribution. Just make sure you establish a repayment plan lasting no more than three years.

Jim Probasco of Investopedia points to the SEPP plan or rule 72(t), which, “allows penalty-free early withdrawals from an IRA, provided you take at least five substantially equal periodic payments over your lifetime.” This makes your IRA distribution a method of early retirement.

There are other ways of paying off debt, such as limiting your monthly spending to put as much money as possible toward knocking out the highest-interest loan. Talk with a financial adviser about how you can best tackle your outstanding debt before you tap into your IRA early.

Categories: Retirement, Financial Education

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