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Paying debt with IRA

First of all, we should absolutely mention that this isn’t a great idea. Taking money from your IRA, 401k, or other forms of retirement savings should be considered an extreme, last-resort measure. Not simply just because you are stealing from your future to create a stop-gap now, but also because of the early withdrawal fees and taxes associated with utilizing this type of savings to pull out cash.

You should really only pull money from your IRA account if it is a last resort to avoid bankruptcy or foreclosure on your home. Here are reasons to avoid doing this, but also some tips if you are out of other options.

Avoid using your IRA as an emergency fund for student loan debt

As we recently discussed, there are other options for making your student loan payments if you fall behind, such as a 90-days forbearance. If you miss a student loan payment, but you have other means of creating additional income to eventually pay it, consider a payday loan or asking family for help rather than pulling from your IRA. The reason for this is simple; the fees and taxes you have to pay on the money you are withdrawing from your IRA will perpetuate your cycle of debt. If removes hard-earned money from your savings, and while you might survive this week, you could easily be in a similar situation next week. 

Investopedia adds these important details on using your IRA to pay off your student loan debt: “If you are younger than 59½, you can still use your traditional IRA funds to pay for college loans, but your withdrawals are likely to be subject to both income tax and early-withdrawal tax penalties. In other words, student loans do not qualify as an exempt purpose to take out an early withdrawal from your retirement account. That said, direct higher education expenses may be eligible as an exempt (penalty-free) early withdrawal, such as tuition, administrative fees, books, and school supplies.”

Rules and penalties for early IRA or 401(k) withdrawal

If you are 59 ½ years of age or younger, you will have ONLY 60 DAYS to replace the funds in your IRA to another retirement fund or back into your account before the federal government imposes their taxes on the amount you withdrew. On top of that, non-taxable rollovers can only be done once per year. So if you are consistently falling short on your monthly financial commitments, dipping into your IRA might not be the best way to go as it is a one-time measure.

If you are considering withdrawing from a 401(k), the rules and fees are even steeper. DaveRamsey.com details this perfectly: “Withdrawing money from a 401(k) early comes with a 10% penalty. You also have to pay taxes on whatever you take out, but the IRS usually withholds 20% automatically. And if you take out a significant amount, it could bump you into a higher tax bracket. So, if you took $20,000 from your 401(k) and that puts you in the 22% tax bracket, you may only get about $12,000–13,000 (depending on state income tax) when all is said and done.”

And that doesn’t even include the taxes if you are under 59 ½, which still apply after those beforementioned 60 days! Do you really need to pull out this money at a 30% interest rate? Seriously consider these ramifications before making this withdrawal.

Savings accounts in jars
Don’t empty the biggest and most important jar

Focus on the real issues here

Where is your money going that is causing you to miss payments? How did you get into this debt situation in the first place? Falling severely behind on payments while still earning a decent income is usually a sign of poor money management. 

In the NerdWallet community forums, Chris Winn provides some excellent insight into a case study that is highly relevant to many of our readers. A submission in the forums details how someone has over $100k in overall debt, despite owning two properties and making very good money. Winn responds to the post with this valuable insight: “…high interest debt accumulation is usually a sign of a cash management problem.  In other words, spending more than you make. These can be caused by impulse purchases, emergency situations, poor communication between spouses, etc. High debt is just the symptom. You need to treat the cause to cure the problem long term. I’ve seen several cases where people did what you are considering and ended up with more debt a few years later.”

Using a retirement fund to pay off a mortgage

So now that you are armed with all the details on taxes and early withdrawal fees associated with pulling funds from an IRA or 401(k), the only real way to make the decision to pay off your mortgage with this money is whether or not the sum of said taxes and fees are cheaper than paying off your mortgage in the long run. The only other factor to take into account is – now that your mortgage is paid off, do the monthly savings equate to stability in retirement? An extremely high mortgage rate from your youth might be killing you in the short term, but if it is the high-interest rate on your mortgage that you are trying to tackle, consider refinancing or restructuring your mortgage agreement instead of paying the extremely high early withdrawal fees and leveraging your future for an immediate gain. 

Other possibilities for paying off your mortgage early depend on increasing your monthly payment by re-allocating funds, adding an additional payment per quarter to aggressively attack your principle, or downsizing your home by using the funds to pay off your mortgage in order to be debt-free in a new, less-expensive home. 

Whatever the reason you have for exploring payment options, just always remember that early withdrawal from an IRA or 401(k) should be considered an act of desperation, and you should explore all other options before arriving at this conclusion.

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