Do you have an IRA – an individual retirement account? If so, you’re headed in the right direction; only 38% of Americans have one, and only 15% of Americans actually make annual contributions to a plan. An IRA gives you a tax-sheltered ability to grow your net worth over the years and create a comfortable nest egg for retirement, and is something you should maximize if at all possible.
One reason an IRA is also good is because it gives you a reserve of funds that you can use in an emergency, should you suddenly need a large amount of money. You’ll have to pay taxes on it eventually, and there are limitations for what you can withdraw and for what reason, so you have to be careful about when you withdraw your funds and for what purpose.
Can you use your IRA to pay off debt, especially if the debt has reached dangerous proportions? Here, we’ll talk about using your IRA for that purpose and the potential consequences of doing so.
The Consequences of Withdrawing Money Early
The simple answer to the question is “Yes”: You can withdraw money from your IRA at any time, for any reason, if you absolutely want to. It’s your money, after all; the government isn’t going to keep you from it.
But, owning and contributing to an IRA, no matter if it’s a traditional or Roth, comes with certain restrictions. If you withdraw your money early, you are subject to a 10% penalty off the top, plus income taxes on whatever you withdrew. You’ll even have to pay taxes on withdrawals from a Roth IRA if you don’t meet certain requirements, which is bad because one of the key advantages of a Roth IRA is the fact that you can withdraw your funds without paying taxes at all (since you already paid taxes on your original contributions).
What are these requirements? For a traditional IRA, to avoid a penalty, you have to make qualified distributions, which are:
- Distributions made after the age of 59 ½
- Payments for unreimbursed medical expenses over 7.5% of your adjusted gross income
- Payments for medical insurance if you’ve lost your job, have received unemployment compensation for 12 weeks in a row, and receive your distributions no later than two months after you’ve been re-employed
- Payments if you become disabled
- Payments to your beneficiaries if you die
- Payments to cover “qualified higher education expenses”
- Distributions to help with a first-time home purchase for you or your family
- Payments to pay for an IRS levy
For a Roth IRA qualified distribution, you have to meet one of the following conditions:
- You have to be at least 59 ½
- You use the funds for a first-time home purchase (up to $10,000)
- You become disabled or you pass away
The only way, then, that you can use funds from your IRA to pay off debt, according to the above information, is to use your distribution to help pay for back taxes owed to the IRS if the IRS has placed a tax levy on you and your assets.
Otherwise, money from an IRA to go toward debt will be hit with a 10% penalty, plus income taxes (the income taxes are assessed on your earnings in a Roth IRA and are assessed on all funds in a traditional IRA).
Should You Use IRA Funds to Pay Off Debts?
The general rule of thumb about taking money from your IRA is this: It should be a last resort when you have no other option.
This happens more frequently with IRAs than it does 401ks because you’re allowed to take out a loan against your account with a 401k. You’re forbidden from doing so with an IRA, so if you can’t find a private loan elsewhere, or can’t find the money to pay down debt or pay for other expenses, you may be forced to use your retirement account as a source of emergency cash.
The big thing is the 10% penalty, along with the fact that you’ll pay income tax – and that could put you in a higher tax bracket for that tax year, costing you even more money. You also can’t replace money you take from an IRA, because you have annual limits to how much you can contribute. That money would not be able to take advantage of compound interest, which further increases the loss.
With that being said, if you must and have no other option, after consulting with a financial expert who knows you and your case, then using your IRA for debt that you can’t pay may be an option. Keep in mind, though, that in a bankruptcy, IRAs are generally protected (up to $1 million or more, depending on inflation).That means if you have to declare bankruptcy, your IRA should be safe. That could be a way to discharge debt without having to use your vital retirement funds.
Bankruptcy can hit your credit hard, but it may be the best option. At least then your IRA funds will be protected and allowed to grow until you retire.