I have been investing a healthy amount in my current 401k with no plan to withdraw it early. I have $3,500 in a rollover IRA which has been sitting in there for about 4 years and I have done nothing to grow it over the past couple of years.

I have ~$3k in credit card debt and I wonder what the cons would be for withdrawing the IRA money early and using it to pay off my credit card debt. Since I would pay a 10% penalty and 35% in combined state and federal taxes, I think that this would net me approximately $1,900.

The $3,500 seems like such a small amount and therefore I don’t see any big risks by taking it out to pay off my credit card debt. Am I missing something?

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    Does your 401(k) plan accept incoming rollovers? If you consider it too small an amount to keep track of, maybe you could roll it into your 401(k) and have one fewer account. – stannius Sep 12 at 16:30
  • What kinds of funds or indexes does your rollover IRA give you access to? As I recall, accounts specifically labelled "Rollover" are just intended to be holding accounts and don't usually have anything more than money market investment options. – Arluin Sep 12 at 21:59
  • @Arluin do you have any reference for that? It doesn't match my experience. – stannius Sep 13 at 16:36

Do not use your IRA to pay off this debt! If the penalties are indeed as high as you state, it's like paying almost 50% interest on your debt!

Your $3500 balance is real money. You can consolidate your rollover accounts if you don't like having small amounts in several places. It's not just some "random account". If you had $3500 in cash right now, would you light $1600 on fire in order to pay down $1900 of debt? Sounds silly, right?

Consider asking a different question: "What's the best way to pay down my credit card debt?"

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    I'm not sure I agree with "it's like paying almost 50% interest". The 10% penalty is hefty, but you'll be paying with post-tax money either way, whether it's from the IRA or savings/salary. – ceejayoz Sep 12 at 16:12
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    Also, paying off a CC debt like that can have a rebound effect on you. Since you are used to having a 3K debt you can very easily rationalise to yourself that it is manageable and very soon run up a similar debt. Slow, orderly reduction generally works better. – theblitz Sep 12 at 16:56
  • OP would also be missing out on continued tax-deferred growth in the IRA. We can quibble over the severity of the penalties, sure. – Rocky Sep 13 at 18:11

Do not use this money to pay off debt.
As others have stated, this would be a huge waste of money.

Further, how do you have that money invested inside your IRA? The stock market is up roughly 50% over the last two years. If your investment has not grown at all during that time, you have it invested very poorly. Do you just have it sitting in cash inside the IRA? Is it in some fund that is really expensive but has worse than average returns? That you could have money sitting in an IRA and have made nothing over the last few years doesn't really make much sense.

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    This is right. Even an inexpensive index fund should have grown significantly in the past few years. – Barmar Sep 12 at 15:18
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    Yeah shame the guy just because he doesnt know much about investing. Way to go – arahant Sep 13 at 18:45
  • @arahant, what, exactly would you like me to say? "Good job"? I didn't call him any names or say he was a terrible person. This is a site for learning about investing and personal finance. You can't learn if you don't receive constructive criticism about mistakes. – Kevin Sep 13 at 19:33

You are not looking at this correctly.

The entire premise of a tax privileged retirement account is for long term growth. The "rule of 72" says that at 10% return your retirement funds will double every 7 years. If you withdraw that money 28 years from now, then that is 4 doublings.

$3,500 * 2^4 = $3,500 * 16 = $56,000.

So you are not really spending "$3,500" to be debt free. You are sacrificing your future. For sure there are other considerations, like opportunity costs, and how holding debt also sacrifices your future. However, don't steal from yourself (in the future) for a short term gain. This is before even considering the 10% withdrawal penalty which comes right off the top. $3,500 should be manageable debt. Solve the problem of acquiring new debt and fix that and get out of debt with a plan. Even if the debt payment plan is only $200 / month.

If you want to combine a savings emergency fund with retirement you might look into a ROTH IRA. Those allow you to withdraw your contributions penalty free. That way you could save for retirement, but also know that in a pinch you can access the cash you've deposited without penalty.

Update to address this point:

I have $3,500 in a rollover IRA which has been sitting in there for about 4 years and I have done nothing to grow it over the past couple of years.

I can see why you feel the IRA is useless if the money has not grown in 4 years, especially in this economy. You should probably look to move it somewhere where hopefully growth occurs. That money should not be stagnating in this economy, that indicates a poor investment. In this context, your desire to "put it to good use" by paying off debt makes sense. However, try to build habits that put you in a stronger financial position. In this case save for retirement, pay off debts, and manage your retirement funds to make sure they are performing.

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    That doesn't make sense. If the credit card is charging 20% interest, it's going to compound much faster than the investment. And 10% is a very optimistic number. – Acccumulation Sep 12 at 17:08
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    @Acccumulation, both valid points. There are definitely numbers where taking the hit make sense. Still, my overall point is to not "rob" from yourself without fixing the underlying problem, otherwise they will end up right back or worse than before when they have $3500 debt + no retirement. – James Sep 12 at 17:29

This is going to sound like a scam because it seems to good to be true, however, it isn't. What if I told you you can make a guaranteed 45% (or more) return on your money? Wow, amazing, must be a scam.

Step 1: Rollover or keep this IRA. Make sure it is with one of the free providers. Step 2: Reduce your lifestyle and your 401K contributions to pay off this CC. Your goal should be done with this in 2-3 months. Make sure you have at least 1k per month to make the payment.

If you really want to set yourself up for success get a second job instead of reducing your contributions and be done with this 8 weeks from today.

You can do it.

  • 5
    I would have up-voted this, except for the "get a 2nd job" bit, plus the unrealistic time frames. Not everyone can get that 2nd job and very few people will be able to find one "today". Also, having a 2nd job can put too much stress on a person and significantly reduce their energy levels, causing their "day job" to suffer. I know this from currently running my own business 30-40 hrs a week after my day job. – computercarguy Sep 12 at 15:47
  • @computercarguy you miss the point. The goal is to make the time frame short, if it is 4 or 6 months does it change his life? Nope. However, lets say he goes all in. Could he be done in 4 or 6 weeks? With such a small amount, the answer is yes. Doing it in an "unrealistic" time frame will change his life far more than the dollars in question. – Pete B. Sep 12 at 16:55
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    If they are getting matching contributions, it may make sense to put money in a 401(k) rather than paying off the credit card. – Acccumulation Sep 12 at 17:10
  • Why is 4-6 months not a short enough time frame? Paying this debt off in 4-6 weeks might be detrimental to the OP (stress, marriage, kids, etc.). Also, many of the jobs I've had take 3-4 weeks for the first paycheck to arrive. – computercarguy Sep 12 at 17:12
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    My point is that there isn't a tone of desperation or immediate need to remove this debt, just a straight up "Can I" question. There's no visible need to drastically change the OP's life by getting a 2nd job or to become miserly because of this debt. Reduce spending may be needed, sure, but not at the rate you're talking about. – computercarguy Sep 12 at 19:33

You have so many options regarding the $3500 to make it grow between now and retirement.

The $3500 just seems like such a small amount and kept in a random account I have done nothing to grow it the last couple years.

If you are like a typical US worker you will have multiple employers over the years, when you move to the next one you will have an opportunity to rollover the money from your current 401K. So the $3,500 would soon have more rollover money.

If you want to only consider the current $3,500 then realize that there are many companies/funds that would be happy to invest your money. An IRA is a type of account, that is defined by your limited ability to spend it before reaching retirement age. Being an IRA doesn't place many limits on how it can be invested. It can be anything from a account paying almost zero, to a CD, to a bond mutual fund, to a stock mutual fund. Even a mutual fund can range from ultra-safe and conservative to ultra-aggressive.

Moving your money from safe to aggressive can be done easily without any tax implications.

If you want some tax implications you can change the account from a traditional to a Roth account. That would cost you that 35% federal and state taxes, but would allow the account to grow tax free. That might not be a possibility now, with the credit card debt but it is something to consider in the future.

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    Converting the account to a Roth IRA does not seem like it will be the right move for OP any time soon. He first needs to pay off the credit card debt, second needs to max out the 401(K), and only then should he consider any Roth conversions. – stannius Sep 12 at 16:29

You take a penalty to use the money in your IRA but you take no penalty if you suspend your 401k contributions to pay off your debt. This automatically puts you ahead because it is like you earned the same amount as the penalty that you would have paid otherwise assuming you were going to use your IRA money.

Personally, I would see where you can alter your lifestyle so that you continue to contribute to your 401k while also saving money elsewhere and using that to pay off your debt.

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    If OP has an employer match, suspending contributions could be as much as 100% "penalty" on the money not contributed. – stannius Sep 12 at 16:27
  • Besides stannius' point, the OP would be paying CC-level interest on the money until the debt is paid off. – Acccumulation Sep 12 at 17:11

As others stated, don't use your IRA to pay off the debt. With the fees and taxes involved, you just aren't going to get a 1:1 ratio between "cash" and debt.

Reducing your spending might be a way to help you pay off that debt. I've used this method for +15 years and it works, even if it takes time.

Before I start, this answer to another question is related: https://interpersonal.stackexchange.com/a/18381/3616

There are probably a lot of things that you buy without thinking about them that can go a long way to reducing your spending that can give you more money to reduce your debt. Daily drinks (coffee, pop, tea, alcohol, etc.), snacks, cigarettes, and lots more can add up to significant spending each week. If you reduce or eliminate those expenditures, they become savings or even debt reduction.

If you spend $8 a day at lunch then $10 for supper, that's roughly $550 a month. Spend $350 at the grocery store instead for a $200 a month savings. That $5 morning coffee is $150 a month. You can still have that morning coffee, just brew it yourself.

If you're already doing this, great! You might want to check out the book "America's Cheapest Family" for other great ways to save. I've read that book 2-3 times to help me figure out where I can "trim the fat" without negatively impacting myself.

Without touching your IRA or 401k contributions, but simply reducing your spending can allow you pay off that $3500 in a year or less. Also, reducing your spending will help prevent that $3500 from constantly regenerating or, worse, growing.

Depending on the interest rate on your credit card and how long you expect to pay it down it might be prudent to liquidate the IRA to pay the credit card. You can figure it out with a bit of math.

First, let's consider the 35% income tax. You will eventually have to pay tax on every penny in the IRA, it's just a question of when and what tax rate you'll have at that point. Do you expect to be in a larger or lower marginal tax bracket when you retire? You'll effectively only pay (or gain) the difference between 35% and your eventual tax rate. Many people retire in lower tax brackets than when they were earning, but some stay at the same bracket or higher, depending on how aggressively they saved. Also, there's some chance that in the future tax rates will be higher or lower, so it's hard to make definite assumptions about eventual tax rates when you retire. Probably somewhere in the 20% to 40% range.

Also worth noting: whether you pay 35% now and let the money accumulate interest for 30 years or let the money accumulate interest and then pay 35%, you'll end up with the same amount. The advantage of a tax deferred account is that you pay the tax once, not that you get to defer the tax. In a normal brokerage account, the marginal tax rate basically changes the rate of interest your investments make, whereas in a tax deferred account your interest rate is untouched (with the tradeoff of smaller initial capital to invest with). It's a fallacy to think that because you pay taxes later instead of now it means you'll be making more money.

Similarly, the 10% penalty for early withdrawal is not trivial, but it is a one-off expense, not an interest rate, and so is effectively a 10% increase on the 35% marginal rate.

In order for it to make sense to pay off the credit card, the credit card debt would need to accumulate faster than your IRA, once you take in to account the difference between the tax rate you have now (effectively 45%) and what it might be when you retire (probably somewhere between 20% and 40%).

Let's say you have a 45% tax rate now (the 35% + 10% penalty), and you expect to have a 30% tax rate when you retire. Let's say your IRA has 5% annual returns, and your credit card is 25% APR. If you leave the money in the IRA, you'll have 70% of your capital earning 5% annually. If you take it out, you'll have 55% of your capital "earning" 25% APR (not paying an interest rate on a loan is the same as earning interest on an investment). How long does your credit card debt need to accumulate interest before it would have made sense to pay it down with your IRA?

70 * 1.05^N = 55 * 1.25^N, N is the number of years until you'd cash out your IRA or hold the balance in your credit card. For this example, N is 1.4 years, so if you had to hold the credit card balance for more than 1.4 years you should cash out the IRA to pay the credit card down instead. This is not an all or nothing proposition, either. Let's say you calculate you can pay down 80% of your credit card in 1.4 years. Then withdraw up to 20% of your credit card debt from your IRA now and pay the rest of your credit card off over the next year and a half.

Feel free to play with different numbers. There's a lot of assumptions you have to make about the numbers, so it makes sense to plug in different values and get a sense of how sensitive the final number is. The point is if you have to hold high interest debt for too long it can make sense to pay it down with IRA money, and you should at least know when that crossover point is.

Note that there can be other factors to consider that are not strictly math based, like how hard it is for you to save money, how hard it is for you to not accumulate credit card debt, and how often you hit the federal maximum for IRA contributions. Also, if you have a 401k at work, similar math can mean it makes sense to take a loan against it to pay down credit card debt. Some 401k plans allow such loans, and the loans mean you don't have to pay the 10% penalty. But you do have to pay it back in to the 401k or face financial penalties.

Point is, retirement account resources are money and there are situations where it makes sense to pull from it. Just do it in a disciplined way.

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