Should I Withdraw from My Roth IRA to Pay Off Debt?

Golden Egg by Mykl Roventine on FlickrAmber writes in with the following question regarding Roth IRA withdrawals:

“I currently owe about $10,000 in credit card debt and have nearly that amount in a Roth IRA I started a few years ago. I share your passion for being debt free and have considered withdrawing the money from my IRA account to pay off my debt. I figure once I’m debt free I can resume Roth IRA contributions and rebuild my account. Your thoughts on this strategy?”

Thanks for writing Amber. I appreciate your desire to become debt free – there is no feeling like it! However, withdrawing money from your Roth IRA to pay down debt could potentially be a bad move. Let’s discuss why.

Four Reasons Not to Tap Your Roth IRA to Pay Down Debts

You might have to pay a penalty if you withdraw from a Roth IRA. Although you can withdraw your contributions to a Roth IRA at any time and for any reason, you will be penalized if you withdraw earnings on your Roth IRA contributions unless the distribution of earnings is qualified.

A distribution is only qualified if you withdraw on or after the date you reach the age of 59 ½; if the withdrawal is made because you become disabled according to the IRS; if the withdrawal is used toward the purchase of a first home; or if the withdrawal left to your beneficiary in your will. The withdrawal of earnings must also be made five tax years or more after your first contribution.

Clearly, most withdrawals of earnings to pay off debt are not qualified. A distribution that is not qualified will be subject to a ten percent additional tax penalty, and you must pay ordinary income taxes on the amount you withdraw. There are no taxes owed on qualified distributions from a Roth IRA.

You diminish the power of compounding interest if you withdraw from a Roth IRA. Even if your distribution is qualified, you will have a smaller balance after you withdraw. This makes for a lower amount of money that can be earning interest, diminishing your returns over time. Once you withdraw contributions from previous tax years, they cannot be reinvested. That opportunity to contribute for that period is gone, forever.

You might be unprepared for retirement if you withdraw from a Roth IRA. A Roth IRA is designed to help you pay for your living expenses when you can no longer work. Withdrawing money from it today may leave you with less money decades from now, increasing the odds of an impoverished retirement.

You may start a bad financial pattern if you withdraw from a Roth IRA. It will likely be easier to withdraw from your Roth IRA again in the future when you need some quick cash after you take your first early distribution. Withdrawing once may start a bad pattern that will keep you from hitting your retirement goals if you make a habit of tapping retirement contributions to pay for your current lifestyle.

All things being equal, it seems best to avoid withdrawing from a Roth IRA to pay off your credit cards and other consumer debts. If you have no other recourse, and your debt is inhibiting your ability to live today and plan for the future, then you might want to take a withdrawal.

If you decide to go this route, I strongly suggest you only remove contributions from your Roth IRA, not the earnings. Allow the earnings to continue to grow, and avoid paying taxes and penalties for withdrawing them early for a non-qualifying event.

Comments

  1. I took a hardship withdrawal from my 401k a few months ago to help pay for my son’s college tuition. I am currently paying $280 a month for the parent loans I took out for my other son. I calculated the amount I would be paying back to the U.S. Dept of Education when my youngest graduates in 2014 and on top of what I’m paying now it would come to about $1200 a month! I decided that I will take out hardship withdraws for the next couple of years instead of taking out loans from the government. I realize I will have to pay state and federal taxes plus penalties on the withdraws, however, I believe I will be better off in the long run. During this wacky economy and the politicians in charge, who knows what will be left in my 401k anyway? Taking a risk, I know, but paying back $1200 a month until I die is not what I want to do.

    • People may think you’re nuts but I agree with you. Americans are being fooled and lulled into a false sense of security with IRA’s. A very rare few are actually able to retire these days anyway. Why be a slave for 40 years to barely have enough to maybe not work; all dependent upon the financial industry. Such a load a crap. The only people getting rich from our retirement accounts are bankers and financials. I’ve learned my lesson and I’m reasonably young. I’m using a chunk of my “investments” to get myself out of debt. I plan to operate on a cash basis only. I’ll have to work for at least the next 20 years (I’m 40). Why not be debt free and then start hoping I have enough to retire.

  2. I agree with Frugal Dad. If Amber can pay off her debt from within her budget rather than withdraw from retirement savings, that is ideal. Additionally, I think the hard road to debt repayment will be better for her in the long run, as making payments on the debt over time will reinforce her will to not acquire more debt in the future, once her current debt is paid off.

  3. Cool site. As a dad, I can appreciate. I get the ROTH question, or similar questions at http://www.seeitmarket.com and my first thoughts are always about behavior. It is the behavior that caused the debt that needs to change if any debt payoff if going to be successful. Try to avoid menatlly bailing yourself out.

    • Yes very true. Similar to refinancing a mortgage to pay down consumer debt. A very high percentage of those people have the same amount of consumer debt again in a few years as they never changed their behavior.

  4. And I believe if you withdraw money from your 401K, and then unexpectedly lose your job, you may have to repay it within 60 days or face penalties and taxes on the money withdrawn if you’re under 59 1/2. There are exceptions, but in this economy, I wouldn’t take the risk.

  5. Would like to suggest as the Roth IRA in question was only recently opened it’s likely the bulk of the IRA’s value is from Amber’s contributions. In this case as was stated above these contributions can be withdrawn at any time, free of tax and penalties.

    Say Amber put in $8000 over the last two years. If the amount of interest charged on the credit card balances is greater than the returns on her IRA investments it might be wise to consider paying off the debt and then resume the IRA contributions.

    ie say if the card interest rates are greater than 10% what sort of investments would be needed in the Roth IRA to provide a 10% or greater return on her contributions? or heaven forbid the card rates are 15% or 20% or more then we’re looking at a high degree of risk to meet or exceed those kind of rates with her IRA investments.

    Maybe one avenue to pursue is a 0% balance transfer to another card(s) as more banks appear to be bringing this back after they had clamped down on transfers the last few years. If not 0% even knocking off 2-3% on $10000 would be a substantial savings.

  6. This summer I did withdraw most of my contributions from my ROTH to pay off debt. The reason was that my job had been eliminated. We have credit card debt leftover from when I allow Hubby to handle his paycheck for about a year and he managed to double his credit card debt by not paying close attention. But paying down a lot of that debt we had a chance to survive on Hubby’s income alone. Otherwise I would not have touched it. Luckily I got a contract position rather quickly and we were able to use my severance to pay down more debt.

    But I hope mine is a rather unique situation.

  7. Amber should start getting immediate benefit by stopping her Roth contribution and re direct the money towards credit card repayment. I agree with other commentator that transferring balance to another card with intro 0% APR should help her avoid further interest charges for few more months (off course she shouldn’t make balance transfer a habit).

    If she promises herself not to use credit card irresponsibly again then I would allow her to take around $5000 from her Roth contribution and rest she can pay off by diverting money from all retirement savings for next year or two.

  8. A few people seem to be writing about this subject at the moment, which suggests that that is a lot of interest in exploring it as a legitimate way to manage significant debts, but I totally share your concerns on the matter, especially in relation to incuring penalties.

  9. Right in Maxine. What gets me is our financial advisor said it is not a good idea to pay off your high consumer debt with our IRAs. You owe tax and you take a early withdrawal hit. The thing is…. It is not that big a hit in the grand scheme of things. It is much better to get out of debt. On $10,000 credit debt the interest each month is most likely $50-$100. Better to get out of that and take a little hit for doing so than keep paying the creditors. It is ok for Wall Street to play with our money and make our investments look like a roller coster, but god forbid you take control by taking it out and paying off the man. I am tired of hearing people say, don’t take it out….you’ll be penalized. BS… They don’t want you to take it out because they need your money to make money, and if you pay off your debt than the banks don’t make their interest money from you. It is all a big sick cycle that most Americans fall into. I say take control. Pay off your debt and than start saving again where you can. Real estate is better than giving it to Wall Street.

    • I agree with you, james. It is our money…sure, we practically sign our lives away for these iras, but I am in the debt bracket too, and I want to do three things in the process-be happy with what I have-stop feeling guilty about money and pay off the debt starting fresh. Yes, I would like to have the money for retirement, but I am living now and need to get a grip.

  10. I think a lot of people are making the assumption that the Roth fund will continue to grow. With the less than a secure market, you may actually have your Roth funds principal lose value, while you are still paying high interest card rates, a double “whammy”.

  11. While generally speaking it’s a bad deal to use an IRA to repay credit card debt (due to taxes and penalties), if you’ve already cut your budget and you’re having difficulty paying the mortgage, paying for food or for the transportation you need to get to work, it may be best both financially and psychologically to just take the plunge and use the IRA money. Just be sure to not get into the credit card trap again. Also, start a proper emergency fund.

  12. Be aware…you have to list the amt you have in your Ira or 401ks on your income tax forms this year (new item added for (2013). Yes, your money will be taken from you to pay for the debt and you will be issued treasury notes, which will NOT be worth anything. So, had you rather pay penalty or let the government have it?

  13. Its perhaps more black and white than represented. My Roth has appreciated only about 20%, in about 12 years. So I’m getting less than a 2% return. If my card rate is > 2%, then its to my advantage, assuming similar returns, to pay off the card. But I’d only withdraw contributed dollars, which in my case, is still 80% of the Roth!

  14. Unfortunately, my wife and I have racked up almost $30K in debt over the last few years with moves around the world and hte birth of our twins. I have some retirement savings ($20K in my wife’s Roth, $12K in my tradtitional IRA, $19K in my Roth, and $12K in my govt TSP). I also know that I will begin receiving my goverment pension of about #3k per month for life in another 5 years (I’m only 43), and will work for another 15 years after that. All that being daid, does it make sense to liquidate just enough from the Roth IRAs to pay off the credit cards? We are already trading down on cars, etc to cut cost, and I figure the money I was paying on CC debt can immediately go straight into my govt TSP savings since there is a very high annual limit… or nearly all, so we can avoid living paycheck to paycheck. Doing so with over $100K iincome is extremely upsetting, even if it is mainly due to the thigh cost of living in HI.

    Thanks

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