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Early withdrawals from your IRA can be costly

Posted by Andrew Chan  November 14, 2008 10:05 AM

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I have $15,000 in credit card debt. I have $40,000 in a Rollover IRA. I have a 1 year old and a 3 year old that are both in daycare so my weekly expenses are high. I charge on my credit card monthly about what I pay for my minimum payment. I was thinking that if I took out $20,000 out of my IRA and paid off my credit card that the money I am spending on my minimum payment I could use for my monthly expenses. I know it is bad to take money out of an IRA but what I am paying in interest on credit cards is going to cost more than taking a hit on taxes by taking out the money out of my IRA. What are your thoughts?

In difficult economic times, one of the more common places that people want to turn to in order to make ends meet is their IRA account. While this may look like an attractive option to get cash, making a non-qualified withdrawal from your IRA before age 59½ can be costly. The federal government and some state governments discourage non-qualified, early withdrawals by imposing steep penalties on these transactions.

The federal penalty is 10 percent of the taxable amount withdrawn. Massachusetts does not impose an early withdrawal penalty. In your situation this would amount to a $2,000 dollar penalty if your withdrawal consisted of pre-tax or deductible contributions (and earnings on those contributions). After-tax or non-deductible contributions to your IRA are not subject to the 10 percent penalty.

In addition to the 10 percent penalty, the amounts withdrawn would be subject to federal and state income taxes unless the withdrawal includes after-tax or non-deductible contributions. If you are in the 15 percent bracket for federal taxes and the 5.3 percent bracket for state taxes, your income tax burden would total approximately $4,000 ($3,000 dollars for federal taxes and $1,000 dollars state taxes). A $20,000 dollar early withdrawal from your IRA could result in taxes and penalties of $6,000 dollars leaving you with less than $14,000 dollars to pay off your credit cards. In this case you would actually need to withdraw more than the $20,000 dollars to end up with $15,000 dollars after taxes and penalties.

There are exceptions to the early withdrawal penalty, however, those exceptions do not seem to apply to your situation. Those exceptions include withdrawals made for:
• Medical expenses (to the extent they exceed 7.5 percent of your Adjusted Gross Income),
• Health insurance premiums paid by unemployed individuals,
• Qualified higher education expenses,
• First time home purchases (up to $10,000 dollars per lifetime), and
• Individuals called to active duty.

As a financial planner, I would generally advise against taking an early distribution to pay off your credit card debt for a variety of reasons including the out-of-pocket costs mentioned above. Having said that, I can certainly appreciate the financial, emotional, and psychological benefits associated with reducing or eliminating your debts.

From a short-term, financial standpoint, I think you should evaluate if it is worth the taxes and penalties incurred to rid yourself of your credit card debt. However, it is just as important to determine how you can continue to satisfy your monthly expenses without incurring new debts while also saving for retirement.

This blog is not written or edited by Boston.com or the Boston Globe.
The author is solely responsible for the content.

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ABOUT MANAGING YOUR MONEY
Local finance professionals share insights and advice on issues such as budgeting, managing debt, and retirement planning.

About the contributors

D. Abraham Ringer is a CERTIFIED FINANCIAL PLANNER practitioner and a Financial Adviser with Morgan Stanley Global Wealth Management in Boston. He is registered in MA, NH, NY and several other states to which his articles are directed. For more information please visit www.morganstanleyfa.com/ringer
Financial Planning Association™ of Massachusetts has 900 members who specialize in the financial planning process. Many of its members engage in philanthropic pro bono work in their communities, recommend legislation, elevate public awareness, promote financial literacy, and advocate for sound economic and tax policies.
Odysseas Papadimitriou is the founder of CardHub.com, a credit card and gift card marketplace, and WalletHub.com, a personal finance site. He has more than 13 years of experience in the personal finance industry, and previously served as senior director at Capital One.

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