High-interest debt can feel like a dead weight, pulling you backwards, away from your future goals or retirement. It can be tempting to pull money out of your Roth IRA to pay off that debt, but is it a good idea?
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Experts explained when you might want to do such a thing, and when it’s probably a bad idea.
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Is It Good Debt or Bad Debt?
The first step is to figure out what kind of debt you’ll be carrying into retirement, according to Joe Buhrmann, CFP and senior financial planning consultant at Fidelity’s eMoney Advisor.
Is it “good debt” or “bad debt?” He explained that good debt is generally the kind you incur for assets that can appreciate, such as a mortgage for a home or a college education — both may also carry additional tax benefits or deductions.
Bad debt is the kind you garner on purchases that typically depreciate, such as consumer debt, credit cards or car loans, and doesn’t usually come with tax benefits. “Bad debt also typically carries significantly higher interest rates than good debt,” he said.
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Assess Which Will Grow Faster
Kristopher Whipple, partner and financial advisor at Kristopher Curtis Financial, suggested asking which interest will grow faster— your investment accounts or your credit card debt?
“With credit card debt interest at record-highs and market returns averaging 9% to 10%, you could argue the debt will grow faster than your investments,” he said.
While utilizing Roth accounts to pay off debt isn’t a wrong idea, it’s just not the most tax efficient, he pointed out.
Lost Growth Opportunities
The problem is that when you take money out of an IRA, you’re not just taking out the money that sits in there now — you’re removing that money’s potential to earn more through compounding interest.
At first glance it may appear hard to justify holding onto an account earning 8% when you could pay down debt costing you 20% or more, but over time, your investment could earn more than that, Buhrmann explained.
“By withdrawing early, you are missing out on the opportunity of having growth in your Roth account for when you need the funds the most,” Whipple said.
Potential Loss of Tax Diversification
Another thing you lose if you take money out of a Roth IRA is the benefit of tax diversification, Buhrmann said.
Diversification means “establishing various buckets of assets” he explained, including taxable accounts like investment or brokerage accounts; tax-deferred accounts, like traditional IRAs and pretax qualified retirement plans; and tax-free accounts such as Roth IRAs.
“If tax-free funds are liquidated to reduce debt, there may be downstream impacts to potentially higher income tax bills during retirement,” Buhrmann said.
Fix the Underlying Issue
The answer might not be just paying off the debt, either. While reducing debt can be viewed as a positive outcome, if underlying spending behaviors are a contributing factor, then debt may resurface, Buhrmann said.
“Were spending issues part of the cause for incurring the debt? If so, can you take steps to better track expenses and make better spending decisions?” he asked.
Technology can also play a role in helping you organize your finances, helping you to better monitor and track your expenses and budgeting.
Tax Implications
You also should consider factors such as your age and the length of time you’ve had a Roth IRA. You do have to be over age 59½ and the account must be open for at least five years for you to withdraw earnings tax-free, Buhrmann pointed out.
Roth accounts are also one of the best ways for you to have control over your taxes in the future, Whipple pointed out. So, if you withdraw from a Roth account, it is tax-free, but at current tax brackets you might not be saving as much on taxes as you think.
On the other hand, if you are at the “very peak of your tax bracket” which is already a high tax bracket, any taxable withdrawals could not only create higher taxes but raise your Medicare substantially, Whipple said.
In that case, “If you have a sizable amount of Roth funds and the debt payoff would not affect your overall portfolio allocation percentage and risk, this may be the right time to use those funds.”
Review and Reassess
Before you decide to pay off debt with a Roth IRA, review the reasons that the debt was incurred, Buhrmann said.
If you acquired the debt due to unchecked spending instead of medical bills, for example, it may be time to establish a budget and stick to it.
“Being overwhelmed by debt is a very common experience for a lot of people, especially those in retirement that feel they have to live a tighter lifestyle than they would prefer because of it,” Whipple said.
You have options that can help you and most likely are unaware of, such as debt restructuring, loan consolidations or requesting a lower interest rate first, debt laddering and reverse mortgages. Think carefully before you take from your retirement nest egg.
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Sources
Joe Buhrmann, Fidelity’s eMoney Advisor
Kristopher Whipple, Kristopher Curtis Financial
This article originally appeared on GOBankingRates.com: Should I Take Money Out of My Roth IRA To Pay My Debt? Experts Weigh In
