Taking Money From an IRA to Pay Off Debt

An Individual Retirement Arrangement (IRA) is a tax-advantaged savings account designed for long-term retirement goals. While you are permitted to use these funds for other reasons, such as paying off debt, doing so has significant financial implications. Accessing retirement savings early can disrupt long-term financial plans and trigger immediate taxes and penalties.

Tax and Penalty Consequences of an IRA Withdrawal

When you withdraw money from a Traditional IRA, the distribution is treated as ordinary income. The amount is added to your total income for the year and taxed at your marginal tax rate. For example, if you are in the 22% federal tax bracket and withdraw $10,000, you will owe $2,200 in federal income tax, plus any applicable state income taxes.

Beyond income tax, the IRS imposes a 10% additional tax on early withdrawals. This penalty applies to the taxable portion of any distribution taken before you reach age 59 ½. Using the previous example, a $10,000 withdrawal would incur an additional $1,000 penalty, bringing the total immediate cost to $3,200. This is a penalty separate from the ordinary income tax you must pay.

The tax treatment varies by IRA type. With a Traditional IRA, where contributions are often made with pre-tax dollars, both the contributions and any investment earnings are taxed upon withdrawal. If you have made non-deductible (after-tax) contributions to a Traditional IRA, a proportional amount of your withdrawal will be tax-free based on the ratio of non-deductible contributions to your total IRA value.

With a Roth IRA, contributions are made with after-tax money, so you can withdraw your direct contributions at any time, tax- and penalty-free. However, withdrawing investment earnings before age 59 ½ and before the account has been open for five years will subject those earnings to both ordinary income tax and the 10% penalty. The five-year period begins on January 1 of the tax year of your first contribution.

Exceptions to the Early Withdrawal Penalty

The IRS provides several exceptions that allow you to access IRA funds without the 10% penalty, though ordinary income tax on withdrawals from Traditional IRAs still applies. For individuals facing financial distress, one exception is for becoming totally and permanently disabled, which allows for penalty-free withdrawals regardless of age.

Another exception relates to unreimbursed medical expenses. You can take a penalty-free withdrawal for medical costs that exceed 7.5% of your adjusted gross income (AGI). If you are unemployed, you may also take penalty-free distributions to pay for health insurance premiums, provided you have received unemployment compensation for 12 consecutive weeks.

Other exceptions cater to specific life events. You can withdraw funds penalty-free for qualified higher education expenses or up to $10,000 for a first-time home purchase. The SECURE 2.0 Act also introduced several newer penalty-free withdrawal options:

• For expenses related to a birth or adoption, up to $5,000.
• For unforeseeable or immediate family emergencies, up to $1,000 per year.
• For victims of domestic abuse, up to the lesser of $10,000 or 50% of the account value.

Alternatives to an IRA Withdrawal

Before tapping into retirement funds, it is beneficial to explore other avenues for managing debt. These options may provide the necessary funds without the same tax consequences or impact on your future savings associated with an IRA withdrawal. Common alternatives include:

• 401(k) loan: If your employer’s plan allows, you can borrow from your account and pay it back to yourself with interest. This avoids immediate taxes and penalties if the loan is repaid on time, but defaulting will cause the balance to be treated as a taxable distribution.
• Personal or debt consolidation loans: Banks and credit unions offer these loans to combine multiple high-interest debts into a single loan, potentially with a lower, fixed interest rate.
• Home equity line of credit (HELOC): This allows you to borrow against your home’s equity, often at a lower interest rate than unsecured loans.
• Negotiating with creditors: Many lenders will work with you to create a payment plan, reduce interest rates, or settle the debt for less than the full amount. Nonprofit credit counseling agencies can assist with this process.

The Withdrawal Process

To take money from your IRA, the process is straightforward. The first step is to contact the financial institution that serves as the custodian for your IRA account.

You will need to complete a distribution request form, which is often available online. On this form, you will specify the amount you wish to withdraw and decide whether to have federal and state income taxes withheld directly from the distribution. You can choose to have a percentage withheld or opt out and pay the estimated taxes yourself.

After submitting the form, the custodian will process your request. You can usually choose to receive the money via an electronic transfer to your bank account or as a physical check mailed to your address.

Reporting the Withdrawal on Your Tax Return

You must report any IRA distribution to the IRS when you file your annual income tax return. In January of the year following the withdrawal, your IRA custodian will send you Form 1099-R. This form details the gross amount of your distribution and indicates how much of it is considered taxable.

You will use the information from Form 1099-R to report the withdrawal on your Form 1040. The total distribution amount is reported on the line for IRA distributions, and the taxable portion is entered on the corresponding line. This taxable amount is then included in your overall income calculation for the year.

If you were under age 59 ½ at the time of the withdrawal, you must also file Form 5329. This form is used to either calculate the 10% early withdrawal penalty on the taxable portion of your distribution or to claim an exception to the penalty by entering a specific code that corresponds to your situation.