Using Your IRA to Pay Off Credit Card Debt

You feel like you're drowning in credit card debt. And while you can't squeeze anything more out of the paycheck, you do have a tidy sum sitting in your individual retirement account (IRA). Sure, those funds are supposed to stay untouched until you retire. But that's a long way off. Might it be a better move to use them (or some of them) now, to get those high balances off your back?

First of all, it’s important to acknowledge up front that this may not be a wise financial move for several reasons. Rules vary, depending on the type of account, but when you withdraw funds early from an IRA, you will likely face taxes and/or penalties, which can add substantially to the cost of taking out that money.

With a traditional IRA, since you did not pay taxes on the money before you put it in, you have to pay income taxes when you take it out. In addition, if you're making that withdrawal before the age of 59½, you will likely owe a 10% tax penalty.

A Roth IRA allows you to withdraw funds tax-free, assuming the money has been there at least five years, because that contribution was made with after-tax dollars. However, you are limited to the amount you've actually contributed; any part of the withdrawal that comes from investment earnings is subject to taxes if you take it out before the age of 59½. These early withdrawals are also subject to the 10% penalty.

To add insult to injury, a significant early withdrawal of traditional IRA funds could bump you into a higher tax bracket. The same would apply to earnings from a Roth IRA, which would be taxed and considered income in the year in which it was withdrawn.

"Paying off credit card debt using your IRA jeopardizes your future retirement savings," says Carolyn Howard, CFP®, founder of SeaCure Advisors, LLC, in Sarasota, Fl. "It also causes you to pay more for the credit card debt due to the taxes on the IRA withdrawal."

OK, you understand you'll be taking a hit. If you wish to proceed, it’s important to follow a plan that minimizes collateral (financial) damage.

Start by listing all outstanding credit card debt, in order of annual percentage rate (APR), from highest to lowest. Decide how much of the total debt you want to pay off. 

Next, check the IRA current balance. When calculating how much to withdraw, take into account any taxes and penalties (remembering that the rules for traditional and Roth accounts are different), along with the amount of debt you wish to pay off.

Calculate whether the total amount you wish to withdraw will put you in a higher tax bracket. If so, consider withdrawing over two tax years, paying off part of the debt one year and one the next.

"It's wise to be as tax-conscious as possible," says Carlos Dias Jr., a wealth manager at Excel Tax & Wealth Group in Lake Mary, Fla. "I always recommend running a projection report with an accountant or software (if you know what to do), potentially spreading the tax liability over several years."

Contact the financial institution that holds your IRA and ask for a distribution form. If you do not need to withdraw the full amount, make sure you're allowed partial withdrawals. When you submit the form, make sure you include all required documentation including how you wish to receive the funds – by check or direct deposit.

Once the funds are in your checking account, promptly pay off the credit cards you earmarked in order of highest APR. Use the money for the intended purpose and for nothing else.

It might be tempting to “scrape a little off the top” for a big-ticket item you couldn't otherwise afford. Don't do it. Leaving a balance on a credit card continues to add an expense until it is paid off.    

There are exceptions to the 10% early withdrawal penalty from an IRA including death, disability and qualified education expenses.

A full list of exceptions appears on this IRS chart. One in particular, known as rule 72(t), allows penalty-free early withdrawals from an IRA, provided you make at least five “substantially equal periodic payments” (SEPPs) over your lifetime. Depending on the amount of credit card debt you wish to pay off, the time frame in which you want to make payments, and the amount you would receive via the application of rule 72(t), this may or may not help.

Even if you qualify for an exemption from the penalty, the regular income taxes on your withdrawal are still due, of course.

Before making any withdrawals, make sure you have considered other options for paying off your credit card debt.

One is going on a budget diet. This consists of taking a hard look at how much money is coming in, how much is going out and making cuts where possible. Whether it’s dropping satellite or cable for over-the-air television, carpooling instead of driving to work, or borrowing books from the library instead of buying them from Amazon, there are ways to cut costs and create a pool of funds to dedicate to debt.

And there are different ways to attack the debt. A number of apps and online spreadsheets promote a variety of debt reduction strategies such as the debt snowball method, which has you paying off the lowest balance account first, while making minimum payments on the rest; then using that money you save on the eliminated account to pay off the next lowest balance card, and so on. Another tactic involves paying off the highest interest cards first.

All tactics involve applying the same amount of money to reduce debut each month – even after one account is paid off (you just apply bigger amounts to each remaining balance) – until all accounts are at zero.

Other methods for paying off debt include:

• Transferring balances to lower-interest credit cards
• Taking out a personal loan
• Borrowing from your 401(k)
• Filing for bankruptcy (in most cases, IRA accounts are protected during bankruptcy proceedings) 

It’s important to examine other options to make sure the path you are on is the right one for you.

"Because credit card debt has such high interest rates, there are virtually no investments that will outperform it," says Cullen Breen, CFP®, president of Dutch Asset Corporation in Albany, N.Y. "Because of this it can make sense to take the money from elsewhere."

Good as it is to get out of debt, using IRA funds to do so comes at a cost – and not just the immediate ones of the taxes and penalties. You cannot effectively replace withdrawn funds since there are limits on the amount you can contribute to your IRA in any given year. If you are already putting in the full annual amount, you have no way to put in more, and so "make up" the amount you'll have lost in savings and interest.

"One of the benefits of a retirement account is the tax-deferred or tax-free growth of your principal. This means that more money is working for you to grow your retirement nest egg. If you remove part of your retirement savings, it will not only provide you with less retirement savings, but you will also have less money compounding for you over time," says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass.

Still, sometimes using an IRA to pay off consumer debt is the best available option. If it’s your best available option, make sure you are well-organized and prepared to avoid traps. Do all you can to minimize the cost to you and your finances, so that when it’s all over you can start afresh on the important tasks of living within your means and re-building your retirement nest egg.