STOP! Call us first!!
Planning to cash in an IRA or some other investment account to pay off debt? STOP!
Ok, first, we don't care what you need the cash for, and we'll be the first to tell you that carrying a heavy debt burden isn't the way to go, so don't worry about getting a lecture from us on that. We just want to tell you what the tax implications will be so you can be prepared for the results of your actions... before you take those actions.
It's something we see far too often and it always breaks our hearts. Someone wants to pay off bills, talks to their broker, cashes in the account, and then is sideswiped by the tax they have to pay on that chunk of change. Often, the account is cashed in because there's a cash-flow shortage, which means a big tax bill won't be easy to pay off. You've just robbed Peter to pay Paul and your peace of mind is gone again. You do have some options, so if you're contemplating ANYTHING of the kind, give us a call first. That way you know what's coming and can make an educated decision.
For example: Client 'A' has big credit card bills, or wants to buy an RV for summer fun. They don't want the debt, so they look at their IRA and decide to take out $50,000 to pay off that new 5th wheel trailer. They call the broker and he asks, 'how much withholding do you want?' (Hint: Now's the time to call your CPA!)
Let's say you go it alone, and ask to have 10% withheld. You get a net check for $45,000 and off to RV land you go. The following February you get a 1099-R Form showing your withdrawal of $50,000 and $5,000 withholding. Your W-2 is also for $50,000 and you have $8,000 withheld. Now you do your taxes and find that because you're not 59 1/2 years old you have a 10% penalty on the IRA distribution and your income tax on $100,000 in income as a single individual is $18,184 plus $5,000 penalty for early distribution total tax is $23,184.
You have $13,000 withheld and now you owe $10,184 for that withdrawal. Without the IRA, you would have had a refund of $2,516. Now the total cost of the new 5th wheel is $45,000 purchase price, $17,700 in additional tax, and penalty for a total of $62,700. Plus, your retirement just dropped $50,000 and you may need to take out more to pay the tax bill you unwittingly created.
Debt is never fun. But you do have options that might make a little more sense. If you want that RV, consider shopping pre-owned, or look around on Craigslist. Get something that's a little older, with a little more character, and has a much smaller price tag. As long as it runs, it'll still help get you that summer fun. And you won't be worried about that big bill while you're trying to soak up the moments with your family.
Working a second job for a little while to pay off that debt is a better way to go, too. If you just gotta have something (and if saving up isn't possible - though it's always the best option), then find side work and use what you earn from that job to pay off your debt. Just remember to give us a call to double-check your withholding so you aren't stuck with a big income tax surprise next year!
If it's credit card debt, look into options like consolidation, transferring the balance to a lower-interest card, or negotiating the payments. There are a number of reputable companies out there that help folks in debt come up with payment plans that work for them. Just be sure you research them thoroughly, read their reviews, check with the BBB, and ask them lots of questions before you sign on the dotted line. Again, feel free to call your CPA for advice.
Really, call your CPA before you make any major moves relating to your money. We'd much rather answer your questions now than deliver bad news later. Saving you money is what we love to try and do, so let us do it! We're part of your financial team, a director of your Board if you will. Let us know what you're thinking, planning, needing, so we can help you get there with your financial health intact.