I’ve run into a few situations recently where clients have asked if it made sense to take early withdrawals from their IRAs to pay off credit card debt. My initial reaction was always to say no, it doesn’t make sense, as I’m sure it’s the initial reaction most of you are thinking as well. If you look online, you’ll find article after article telling you it’s a bad idea, and most financial planning gurus would fall in that line as well. However, I wanted to go down the rabbit hole and see what it would cost to look at both options.
Meet the fictional Jones family: They are your average 4-person family in their mid-40s with children in middle school and high school, that for one reason or another have amassed a good deal of credit card debt and now are trying to dig themselves out. They have an adjusted gross income of $180,000, an IRA of $250,000 averaging 6% per year, and credit card debt of $30,000 being charged 19.9% interest. If you recall the rules surrounding Traditional IRAs, contributions are tax deductible, growth and any dividends and interest received in the IRA are tax deferred, withdrawals are taxed at your current income tax rate, and if you are less than 59 ½ years old, there is an added penalty of 10% for withdrawals (with few exceptions).
If the Jones family wanted to have their credit card paid off in 5 years, they would have to make payments of $795 per month and it would cost them $17,512.10 in interest. Including the principle balance of $30,000, their total cost would be $47,512.00 to repay the debt to the credit card. If they withdrawal $30,000 from their IRA, they would have to pay an extra $9,420 in federal taxes and $3,333 in penalties for a total cost of $42,753.
Wait a minute! Is it really more cost effective in this situation to use the IRA??? Not necessarily. It really comes down to the opportunity cost. What is opportunity cost you ask? Opportunity cost, in this situation, is the cost of the choice that was made to withdrawal funds from the IRA to pay off the credit card balance versus paying the card off over the 5 years as originally planned. Although $4,759 was saved by paying the taxes and penalties utilizing the IRA versus paying the credit card interest over 5 years, we must look at the big picture. If the funds continued undisturbed in the IRA and continued to average 6% for the next 20 years, the Jones family would have $801,784 at the end of the 20-year period. However, since they chose to use the funds from the IRA, the balance was reduced to $207,247 ($30,000 + $9,420 + $3,333). Their new balance averaging the same 6% returns over the next 20 years would now only become $664,669. That’s a difference of $137,115. There is the Jones family’s opportunity cost.
So, then it’s not more cost effective to use the IRA? It depends. If the Jones family is disciplined enough to reinvest, or pay themselves back, the $795 per month back into their investments for the next 5 years, they would bring their balance up to $797,702 after the same 20-year period, which is pretty close to what the balance would have been otherwise. They also would have had the benefits of a paid off credit card and all the reduced stress and anxiety that comes with that.
So, what is the right answer? It comes down to your specific situation. How much credit card debt you have, what interest rate you are being charged, the returns you are receiving on your IRA, if you can maintain the discipline of “paying yourself back,” etc. There may also be other options, like borrowing from your 401k, applying for a lower interest loan, using the snowball effect to pay multiple credit cards, and much more.
The point of this article is simply to say that, depending on the situation, withdrawing money from your IRA may not be the worst thing in the world. Sometimes we must wipe the slate clean, so to speak, to be able to rebuild and gain confidence.
The example provided is hypothetical and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing. No strategy assures success or protects against loss. Investing involves risk including loss of principal. Consult your advisor prior to making any financial decision. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.