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Should I Use My IRA to Pay Off My Debt? – Donald

“Dear Steve,

I have had this thought to reduce our debt and to better manage our finances. It is quite complicated (as I am sure most situations are), so I will do my best to present all the information.

My wife and I (we are in our mid 30s) have a credit card with $7k on it and two personal loans (which used to be credit card debt) of $9k (should be paid off in a little over 2 years) and $23k (brand new and won’t be paid off for 6 years). We have never missed or been late with a payment to our creditors, so there is no issue with them.

I have a rollover IRA from a previous employer worth about $30k. I have had it for 5 years and it is not worth any more now than when I started. Our budget is already extremely tight and we are behind $400 each month and quickly running out of money. My wife quit work last summer to stay home with the children (this is extremely important to us) and to raise our newborn who graced us with his presence in October. Furthermore, I have not been able to start on my current employers 401K program either for the same reasons.

So my idea is this: We would cash out the IRA knowing that I would incur a 10% penalty. We are also aware that the cash would be considered income for the year and would be taxed on it. But using the cash, we would pay off the $9k loan and the $7k credit card – this would get us on the plus side monthly by not having to make the payments any more. Then we would use some of the cash to purchase a new roof for our home as it is in desperate need of repair. Whatever is left over would be put into savings, used to start a Roth IRA and to pay any taxes. Then we would attempt to refinance the $23k loan to obtain better terms (i.e. lower interest rate, lower payment, fewer years or a combination of these). Finally, being ahead of the game at this point, I could start to contribute to the company 401K plan and my wife could continue to stay at home with the kids.

I know many say you should never cash out your retirement, but does this plan sound like a good idea?

Should I use my Rollover IRA to pay off a majority of debt?

Donald”

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The Answer

 

Dear Donald,

I just want to speak honestly and bluntly, that’s a really dumb move. You can see a bunch of previous answers on the same subject. I urge you to read them, click here.

Bottom line, you are struggling, if you tap the IRA you are giving up funds that are protected in bankruptcy. What is your game plan when you give away all of your retirement, can’t save new retirement money and still living month to month? And you will soon enough. Your plan just gets you back to a break even place but you really need that and much more to make a big difference.

I don’t blame you for this horrible decision. It is a typical knee-jerk reaction many people make. They simply fail to see the money in the IRA, 401(k), 403(b), for what it is. That money is the stuff you are going to eat with when you are old and not making money anymore. If you leave it and let it grow it will be worth up to a couple of hundred thousand by the time you need it. If you cash it in it will only be worth $30K minus penalties and taxes.

If you keep draining your savings and retirement like a piggy bank, you better select a favorite brand of dog food because that’s what you’ll be eating when you are old if you keep this up. Harsh, but true.

I hope I didn’t sugar coat that too much.

A better plan of action is to get a grip on where your current cash is going with the new income arrangements. You can do this by creating a spending plan. Follow the instructions beginning on page 81 of my free download book, “Eliminate Your Debt Like a Pro.”

Once you do that let me know how short you really after you’ve tracked the cash for a month.

What was the new $23,000 loan for?

Big Hug!

Should I Use My IRA to Pay Off My Debt?   Donald
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About Steve Rhode

Steve Rhode
Steve Rhode is the Get Out of Debt Guy and has been helping good people with bad debt problems since 1994. You can learn more about Steve, here.
  • http://evan-selwyn.webstarts.com/ Jacob Loveney

     Some Roth IRA distributions will be subjected to taxes and penalties, even if they are only distributions of the contributions (rather than distributions of the contributions and earnings). Please look up the term “qualified distribution” in relation to a Roth IRA and/or talk to a specialist who can offer legal or tax advice before following the suggestions outlined in this original post.

  • Lori

    at one time i had 7 credit cards i paid 5 off and cut them up, the two i have left have a total debt of 19,000.00. these were used to help my mom during her sickness of 3 yrs. i make monthly payments but now my income has gone down and i am behind about 100.00 on one of them. i have an ira of about 10,000.00 and just would like to take 5 or 6 thousands just to make my payments afordable. i dont charge on these and plan to close them ince they are paid.

    • GloriaDV

      Honest question – I really don’t understand. How can one assume that an IRA will be worth hundreds of thousands of dollars in 30 years? In the last 5, mine has earned $1000 on an initial investment of $10,000. The money my parents put away for the last 30 years was worth hundreds of thousands for a bit, but they (and millions of others) lost most of that value at the last minute before retirement and are now SOL. Why are we still supposed to assume that IRA’s will be our bread and butter in retirement and suffer under debt right now?

      I am a teacher with a 403b (worth about 15% less than I have contributed to it) and a pension in 19 years. I cashed out the IRA, paid off the credit card bills. Now I am able to purchase years of experience to add to my retirement & up my contribution to the 403b, and get better disability insurance. Why is this a “really dumb move?”

      • http://GetOutOfDebt.org Steve Rhode

        Gloria,

        Simple, historical trends show the market is up more than it’s down. We happen to be in a down phase right now. Cashing out funds now and then repurchasing the same number of shares latter would be financial suicide, sell low, buy high.

        The stock market has outperformed any other investment vehicle over the long haul.

        Leaving funds in the market before retirement is not wise. They should be liquidated out in a stepped plan to move those funds into a more stable vehicle so that money needed in the next few years isn’t subject to sudden market forces. Otherwise, people can find their money they need in the next couple of year to be worth a lot less.

        You made an initial investment of $10,000, but imagine how big your rate of return would have been if you had either continued to invest during these down times or made that investment in stages. That’s the beauty of dollar cost averaging. The rate of return of mutual funds has been pretty good in the past couple of years. and investments made when the market was low would pull up investments made when the market was high. That’s the beauty of dollar cost averaging.

        There are a number of other factors to consider when looking at returns. For example, there is the value of money lost due to inflation. A dollar invested 30 years ago is worth more than a dollar invested today. There are take benefits for participation in many retirement vehicles, pre-tax investing for example. So let’s say you were investing between 1969 to 2009, assuming you are retiring today. Over that time, every dollar you invested would be worth about $6.54 now using the compound annual growth rate of a average stock market based investment. So let’s say over that time you have made $30,000 worth of investments, it would now be worth about $200,000.

        But over the very long run, the stock market has had an inflation-adjusted annualized return rate of between six and seven percent. – Source If you had left the $10,000 in the IRA you would not have lost about $3,000, 30%, to taxes and penalties instead using the statistical rate of return for the market that $10,000, without you making any additional investments, would be worth between to $18,000 to $20,000 a decade from now. By tapping those creditor protected funds that $7,000 you got cash in hand today cost about $19,000 in future value a decade from now.

        You also have to factor in the vehicle the funds are invested in. A low rate of return might just mean the underlying investment may need to be moved. If the IRA is in mutual funds than some emerging market funds are returning as high as 69% in the last year if you are willing to take more of a risk. A set and forget approach to 403(b), 401(k) funds would not be the best approach.

        If you are happy with your path, great. It appears to have bought you some peace of mind and that does have a value.

        I don’t know more about your situation but just purely from an academic POV if your problem was solely credit card debt you could have decided to pursue bankruptcy, addressed the credit card debt or discharged it, not touched the IRA and then been able to up your contributions to your 403(b).

        Steve

  • Donald

    Steve,
    I really appreciate the advise and the candid talk. I don’t want anyone sugar-coating their advise to me so your words are well received. I needed someone to tell me like it is. We have decided not to touch the IRA and to find another way to bridge the gap in our income.

    To answer your $23k loan question, it was answered in the second paragraph: it is a loan to pay off a credit card.

    DJ

    • http://GetOutOfDebt.org Steve Rhode

      Donald,

      Oops, missed that. It’s what I assumed.

      Granted not every situation is the same but from helping people since 1994 the typical pattern I see is that rather than tackle the underlying problem people will drain savings and investments which temporarily solves the problem but only pushes the inevitable out into the future. Since the 23K was for a consolidation it makes logical sense for you find a local bankruptcy attorney you like and go talk to them.

      Discharging your past debt with bankruptcy will give you the breathing room you need to make it each month and save.

      Keep me posted on how this goes. I’m really concerned about you.

      Big hug.

      Steve

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