One important step on the path to financial independence and security is getting yourself out of debt. Or, more accurately, it’s getting yourself out from under the burden of consumer debt (such as credit card debt) or any other debt that you have to carry at a high interest rate.
In some situations, you pay interest to improve your overall financial situation; an affordable home mortgage, for example, can contribute to your long term security. But high interest consumer debt generally won’t help you reach your long term goals.
While it’s generally best to avoid taking early withdrawals from an Individual Retirement Account (since you’ll miss out on the long-term tax advantaged growth of those funds, and you’ll never be able to repay your account for the amounts you withdraw early), in some limited situations it might make sense to make such a withdrawal in order to pay off your high interest debt.
How is Your High Interest Debt Affecting Your Overall Financial Situation? The first thing to examine is how your current debt might be affecting your finances overall. For example, are you struggling to reduce the balance of that debt (perhaps just making the minimum payment each month on a high interest credit card, for example)? In general, the more disruptive (and expensive) it is to continue carrying high interest debt, the more it might make sense to consider taking an early withdrawal from your IRA in order to pay off that debt.
How Likely Are You to Pay That Debt From Other Sources? Another important part of your analysis is deciding how you might be able to repay your high interest debt with other funds. For example, if the amount of debt is relatively small, could you pay it off in full by using the tax return you may expect to receive next year? Or perhaps you can pay down that debt with an end-of-the-year bonus you expect to receive at work.
But if you don’t anticipate having any resources available to pay down your high-interest debt, then it might prove to be a good financial decision to pay that debt using an early withdrawal from your IRA.
How Likely Are You to Avoid Incurring Future Problem Debt? Note that taking an early withdrawal from your IRA reduces how much you’ll have available for retirement, and sometimes significantly so. Taking an early withdrawal of $3,000 might not sound like much, but if that same amount is allowed to grow tax free at a 6% rate for 20 years in an IRA it would be worth almost $10,000.
It’s therefore essential not to think of your IRA as a piggy bank or slush fund that you can use to pay down your debt whenever things get a little bit out of hand. Only consider taking an early IRA withdrawal if paying off high interest debt is truly an isolated occurrence.
Sometimes individuals who have a relatively high net worth and otherwise stable finances can find themselves in situations where they’ve accumulated too much debt. In a small number of these situations they may wish to consider a one-time early withdraw from an IRA to pay off that debt.