When you’re in a financial jam, it can be tempting to take money out of your IRA. But the reason for your IRA is right there in the name—it’s an Individual Retirement Account. When you take money out of an IRA, you’re making it harder to stay on track for retirement, as you’ll pay a lot in fees and taxes and you’ll lose out on future earnings. If you’re in a situation where you feel like you must take money out of your IRA to pay debt, make sure you create a plan that lets you do so as thoughtfully as possible.
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
Penalties and Taxes
Certain penalties exist specifically to discourage you from taking money out of an IRA prior to retirement. These penalties and the tax ramifications of withdrawals vary depending on the type of account.
When you make withdrawals prior to the age of 59 ½ from a traditional IRA, you must pay a 10% fee. You’ll also have to pay federal and state income taxes on the amount you take out. You should also keep in mind that depending on the amount you take out, it’s possible for a withdrawal to bump you into a higher tax bracket.
Contributions to Roth IRAs are made with after-tax dollars. Since you’ve already paid taxes on this money, you have the ability to take it out without penalties or paying taxes. But this is only the case for the contributions, not the earnings. The earnings grow tax-free, and in order to withdraw earnings, you must be over the age of 59 ½. You must also have had the account for at least five years, otherwise, you’ll end up paying taxes and a ten percent penalty fee. As with withdrawals from a traditional IRA, depending on the amount of the earnings you withdraw, it’s possible that you may end up in a higher income tax bracket.
As you can see, there are a lot of penalties and tax implications that come with taking money out of an IRA. Though this alone is quite a deterrent, the biggest concern is almost always the loss of future gains. When you take money out of an IRA, you don’t just lose the money you take out—you also lose all the future earnings that money would have made you. This is also why you can’t “pay yourself back” for the money you take out. Even if you put back the same amount that you took out, including what you may have had to pay in penalties, you still won’t end up with as much as you would if you had never taken the money out.
Early Withdrawal Penalty Exceptions
There are a few exceptions to the 10% withdrawal penalty. These include qualified higher education expenses, a first home (up to $10,000), and health insurance premiums if you’re unemployed. No withdrawal penalty means it may not be as detrimental to use the money in your IRA, but it’s still usually not a good idea. Again, this money is for retirement, and even if you don’t pay a penalty, you still lose out on the interest you would have gained on that money.
If You Do Take Money Out
In a perfect world, you would never take money from an IRA to pay debt. The reality is that sometimes, you may not have any other choice. In that case, the best you can do is create a plan that minimizes the damage as much as possible.
Before you take money out of your IRA, start by figuring out exactly how much you really need. The best way to do this is to face your debt head-on. Write down how much debt you have and the annual percentage rate (APR) for each amount. How much of this debt do you absolutely need to pay off? Your focus should be on higher interest debt.
Once you have a number, figure out how much you’ll need to take out. You’ll need to account for all the fees and taxes you’ll need to pay, so you may need to withdraw a larger amount than you’ll be putting toward your debt.
Next, check if the amount you’re planning to withdraw will put you in a higher tax bracket. If it does, you may want to withdraw the amount over two years. Once you’ve made the withdrawal, make sure you use the funds for their intended purpose and nothing else. Finally, it’s important to understand why you went into debt in the first place and create a plan to avoid sliding back into debt.
Work with a Financial Advisor
There are very few circumstances when you should take money out of your IRA to pay debt. But, in certain cases, it may be unavoidable. To prevent yourself from ever getting in a position where you’re tempted to use your IRA to pay debt, make sure you build an emergency fund, have a solid budget, consistently pay off existing debt, and work with a financial advisor from Good Life Financial Advisors of Mount Pleasant.