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How Should I Use My Inheritance to Reduce My Debt? – Jason

“Dear Steve,

Huge amount of credit card debt. One card 40K @ 7.99%, another 7K @ 11.99%, 8.5K @ 3.99%, and 4K @ 21.99%. Plus, 2 car loans total 20K @ 6.99%(these vehicles are used for work/pleasure – 85/15). My income is down from an average of 100K to now about 45K( economic influences beyond my control). We also have rental income on 2 properties ( one has a mortgage of 1100/month) with an income of about 42.5K(as long as they stay rented). Add our primary home mortgage to the mix of 1800/month. We are struggling. All of the payments prevent us from making any headway. We are surviving. No vacations since 2008. :
Recently I received an inheritance of 39K and a IRA inheritance of about 20K.

Should I use all of this money to paydown our debt? I understand the penalties with cashing in the IRA. I believe paying off at least all of our CC debt, that will give us the ability to begain building an emergency fund and allow us to maybe even take a vacation.

I look forward to your advice.
Thank you,

Jason”

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The Answer

Dear Jason,

Hum, an interesting situation for sure.

The thing that makes it a bit of an uncertain puzzle is that there are two equally valid ways to look at this.

On one hand you have the ability to repay the debt and satisfy the debt with the creditors. On the other hand you have a responsibility to prepare for a better financial future to take better care of your future and retirement.

I’m almost never a fan of touching creditor protected funds to repay debt. It can cost you a huge amount in the long run. See Here’s Why a 401(k) Loan to Pay Off Debt Can Cost You a Massive Amount in Retirement.

On top of this we also have the reality that your income has more than halved and there appears to be no expectation that it will return to previous levels any time soon.

[Insert 15 minutes of me staring at the screen and pondering the situation.]

How about this. I’m a huge fan of balance in approaches. Here is seems to make the most sense from my outside and impartial point of view with the information at hand.

  1. Leave the IRA money alone and protected from the creditors. Leave it in an IRA and let it grow for your future.
  2. Of the $39,000 in inheritance, take $3,900 and earmark that for a vacation or to have fun with.
  3. With the remaining inheritance money of $35,100 you could pay off $11,000 of your highest interest rate debt and $24,100 of your 7.99% debt.
  4. Or you could settle all of your $59,500 worth of credit card debt probably. The debt settlement route would inflict some pain but this way you could probably resolve all of your debt. Debt settlement has some consequences but it is a valid option worth pursuing since you have the cash on hand to settle. You can click here for more information on debt settlement.

The bigger issue here is does eliminating the credit card debt alone make up for the reduction in income and the answer is probably no. With the information you’ve shared I bet this still leaves you struggling.

So let me give you some homework here and ask you to come back with an update in the comments.

Based on your current income, after meeting your basic expenses, how short each month are you? I would imagine that a big part of your unsecured debt is actually the result of putting expenses on cards you can’t afford now. And unless we get you back to a situation where you are living within your income, you will be back in the spot again after spending all the inheritance money. And that’s not where I want to see you wind up.

Please post your responses and follow-up messages to me on this in the comments section below.

Big Hug!

How Should I Use My Inheritance to Reduce My Debt?   Jason
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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.
  • Robert Platt Bell

    Steve –

    These questions from readers are never clear, but it appears that the fellow is saying that he inherited an IRA of $20,000. Correct me if I am wrong.

    The rules for inherited IRAs are tricky.

    If you are not a spouse, the options are more limited, but taxes must be paid on the money – eventually. You can cash it out, but this may knock you into a
    higher bracket, which will result in the highest tax burden to you.
    If the person who left you the money had not started withdrawing the
    money yet (reached age 59-1/2 or the mandatory year of 70-1/2) then you
    can spread out the payments over five years – which may keep you in a
    lower tax bracket.

    See: IRS publication 590:

    “Taking balance within 5 years. A beneficiary who is an individual may be
    required to take the entire account by the end of the fifth year
    following the year of the owner’s death. If this rule applies, no
    distribution is required for any year before that fifth year.”

    So, he will have to pay taxes on an inherited IRA, if it is from his parents. He cannot “roll over” the IRA into his own account. And he will have to withdraw and pay taxes on that amount within five years.

    One approach is to spread this out over five years to minimize the tax burden.

    I would consult a tax adviser for more details.

    His situation sounds a lot like mine – three years ago. We had houses, cars, and lots of debt. I sold off most of it and am now debt-free.

    Getting spending under control was the big deal – that and cutting up credit cards.

    At least he has some low-interest rate cards – that is a plus!

    –Bob.

    • http://GetOutOfDebt.org Steve Rhode

      Excellent points.

      I guess it really depends on:

      “The beneficiary form on file with the custodian of an IRA controls both who inherits it and its ability to be stretched out. If people other than a spouse are named as heirs, they must begin taking distributions from the account by Dec. 31 of the year after inheriting, but they can draw these out over their own expected life spans, enjoying decades of income-tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA.” – http://www.forbes.com/forbes/2010/0628/investment-guide-stretch-ira-beneficiary-five-rules-inherited-iras.html

      As with every question we can do the best with what we’ve got and comments like your help to raise additional points and have a broader discussion about other points to ponder. Thank you very much.

      • Robert Platt Bell

        Exactly. I think he needs to talk to an accountant. He might have to cash in that IRA in as little as five years, depending on circumstances. I think it depends on whether his Dad (or Mom or whoever) had started to draw from it already or not.

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