Many people have significant amounts of money tied up in their IRA accounts and yet carry significant amounts of debt. If this describes you, it may be tempting to take money out of your IRA and pay off your debts. Although the standard financial advice is not to touch your retirement money until you retire, whether it makes sense for you to pay off your debts with IRA money depends on your particular circumstances.
High Debt Load
While it may be tempting to raid your IRA account in order to pay off bills when you have a substantial debt load, it may not be a good idea. In a worst-case scenario, if your debt load causes you to file for bankruptcy, assets held in retirement plans, such as IRA accounts, enjoy special protection from creditors in bankruptcy. IRA accounts cannot be used to pay debts in a Chapter 7 bankruptcy as long as the value of the account is under $1 million. If your IRA funds are from a rolled-over 401(k), the account cannot be taken, regardless of value.
If your investment style is very conservative and your debts are very high-interest, it's possible that you'd be better off financially if you use retirement money to pay off debt. For example, if you have a credit card balance with an interest rate of 16 percent, and you have money enough in your IRA to pay it off which earns about 3 percent a year, you may gain substantially by paying off the debt with funds from the IRA. On the other hand, you must take into consideration the taxes and penalties you would incur, as well as your long-term losses.
Long-Term Financial Loss
As of 2012, you can invest $5,000 per year in an IRA account, and that amount increases to $6,000 per year if you are age 50 or older. If you withdraw money, however, you cannot make up the difference to catch up later. If you withdraw $20,000 and then you win $20,000 the following year at the casino, you cannot replace that money in your IRA. You can put in your maximum of $5,000 -- or $6,000 -- and no more. Depending on the amount you withdraw to pay off your debts, this may result in a significant long-term financial loss by the time you retire, compared to if you had left the money in place.
Roth or Traditional
Tax ramifications often make the decision to withdraw money from an IRA account an unattractive one. With a traditional IRA account, you pay income taxes on the amount you withdraw at your ordinary income tax rate. In addition, you pay a 10 percent penalty on the amount you withdraw if you are under age 59 1/2. With a Roth IRA, you do not have to pay any taxes on contributions that you withdraw -- you may withdraw contributions at any time, tax- and penalty-free. However, any investment gains you withdraw will be taxable at your ordinary income tax rate if you are under age 59 1/2. The 10 percent penalty also applies.
Craig Woodman began writing professionally in 2007. Woodman's articles have been published in "Professional Distributor" magazine and in various online publications. He has written extensively on automotive issues, business, personal finance and recreational vehicles. Woodman is pursuing a Bachelor of Science in finance through online education.