Credit card debt can be a financial killer, making it tough to get ahead on your financial goals. On average the typical American household with outstanding credit card balances owes $16,048.
When credit card debt is putting pressure on your budget, you may be tempted to look to your individual retirement account for relief. While you could draw on your Traditional IRA to pay down some or all of your credit card debt, it’s not something you should do without considering the pros and cons first.
Credit card debt can cost you plenty if you’re paying high interest rates on what you owe. Taking money out of your Traditional IRA to pay off those cards can get you debt free faster than if you were just making regular payments each month. Depending on how high the annual percentage rate is on your card, having that debt disappear could save you a decent amount of money in interest.
Once you’ve gotten rid of your credit card debt, you can use the money that went to your monthly payments to work toward other goals, starting with reinvesting the extra money into your retirement accounts. You could also add to your emergency fund, start a down-payment savings fund for a house or, if you already own a home, accelerate your mortgage payoff.
While there’s something to be said for getting the credit card debt burden off your back, there’s a good reason not to use your Traditional IRA to do it: taxes. Traditional IRAs are funded with pre-tax dollars. That means that when you make withdrawals in retirement, you must pay income tax on any distributions. Besides that, the IRS tacks on a 10 percent early withdrawal penalty when you take money out of your traditional IRA before age 59½.
Even if you’ve saved yourself money by avoiding the credit card interest, you may end up costing yourself more in taxes by breaking into your Traditional IRA early. For one thing, a large withdrawal could push you into a higher tax bracket, which may increase your tax bill or shrink your refund.
The IRS does allow some exceptions to the early withdrawal penalty rule, but they’re limited and don’t include paying for credit card debt. For example, you may be able to avoid the penalty if you’re withdrawing money from your IRA early to pay for unreimbursed medical expenses, purchase a first home or pay qualified education expenses.
With a Roth IRA you can withdraw your original contributions penalty and tax free at any time. Your earnings are a different matter: If you take out any part of your earnings before you are age 59½ and have also had a Roth account for at least five years, you may be subject to federal income tax and the 10 percent penalty on that portion of your withdrawal.
Aside from the tax implications, you also should consider how withdrawing money from your Traditional IRA affects your long-term retirement plan. When you take money out early, it’s no longer earning interest. You can add money back to your IRA but only up to the annual contribution limit, which is currently $5,500 ($6,500 if you are age 50 or older). If you were to take out $20,000 to pay off credit cards, it would take you roughly four years to put it back and you’d be four years behind forever. In the meantime you’re missing out on the power of compound interest.
Before You Tap Your IRA
If you still think that withdrawing money from your Traditional IRA to pay credit card debt makes sense, be sure that you’re approaching it correctly. Start with figuring out how much money you need to withdraw, then calculate how much you’ll owe for the 10 percent early withdrawal penalty, as well as what you’ll owe for income tax. Then compare that to the interest cost of your debt. Are you going to end up with savings or a tax deficit as a result of using your IRA to pay off your cards?
If you’re going to owe more in taxes than you would save, consider which other avenues you have for getting rid of your credit card debt. Transferring your balances to cards with a lower or even zero annual percentage rate is one option. Getting a personal loan to consolidate debt might be another. You could also consider borrowing against your home equity to get cash to pay off credit cards.
If you do end up using your Traditional IRA to pay off credit cards, you should commit to not running up balances on your cards again. Aim to recoup your missing retirement savings by maxing out your IRA going forward and supplement your savings with a 401(k) if you have access to one. Making retirement saving a priority once your debt is gone may help to offset the loss of investment returns associated with an early IRA withdrawal.