At the end of last month, I updated my debt payoff plan with a goal towards paying off my credit cards by next April and my personal loan by next summer.
After I underwent this exercise, I started to explore my other options for paying off this debt. I had already used virtually all of my emergency savings to pay off the first large chunk of this debt several months ago. The remainder of my investments are in either a retirement account or my business accounts.
But could there be another option?
Pay Off Debt With… an Inherited IRA?
As of the end of last month, I had approximately $165,000 in an IRA that I inherited from my Mother in 2016. Because I received this account before the Secure Act became law in 2019, I must take required minimum distributions each year, but instead of withdrawing the entire account balance within 10 years, I am able to spread my distributions over my life expectancy.
The nice thing about an Inherited IRA is that I do not have to pay a penalty on early withdrawals, although I do have to pay personal income tax on my withdrawals.
So theoretically, I could take out enough money to pay off my debt – approximately $40,000 and I would owe about $9,000 in taxes on that distribution.
When looking at my debt payoff plan, it looked like I would have to pay approximately $2,000 in interest on my remaining consumer debt (not counting my car loan).
So from a purely financial perspective, paying off my debt with the inherited IRA doesn’t make sense. I would actually save money by paying off the debt over time… by a lot.
But this chart doesn’t tell the whole story.
Why Paying Off Debt is Important Emotionally
I’ve had debt for as long as I can remember. I applied for my first credit card during my freshman year in college and have struggled to get out of debt ever since.
After having been in debt for almost 30 years, I have a bit of experience about how debt can affect us emotionally. Carrying debt is stressful, even if you can afford the payments.
This is because debt increases your monthly fixed monthly costs. It hinders your ability to create an emergency fund or save for retirement. It causes anxiety and hurts your credit score.
Even though my net worth has been going up each month, the fact that I still have debt has hung over my head like a wet towel.
In a nutshell, it sucks.
It is so discouraging to get paid and then allocate all of those funds to a credit card or loan payment rather than adding it to my retirement account or emergency fund.
But even though I’m well-versed in how stressful having debt can be, I still wasn’t sure whether I should pull money from my Mom’s account (which I vowed never to do, except for the RMD’s) to pay off my debt.
Why Using an Inherited IRA to Pay Off Debt is a Bad Idea
This wasn’t an easy idea or something that I decided to do without giving it some serious thought.
There are two main reasons you should NOT use an inherited IRA to pay off your consumer debt. First is because of the tax hit you will take and second is your propensity to incur new debt.
The Tax Implications of Withdrawing from an Inherited IRA
I will likely owe about $9,000 more in taxes as a result of this decision. The interest I would have paid on my debt while paying it off was around $2,000. So the decision to pull funds from an inherited IRA to pay off consumer debt will cost me about $7,000.
However, I decided to take the hit this year for two main reasons:
- My business is growing and I will make less income this year than I anticipate earning next year; and,
- My ex-wife and I will still be filing a joint tax return in for the 2024 tax year, so I am able to use the married filing joint tax tables for one more year.
I anticipate my income will go up next year and I will be divorced at the end of 2025, meaning that I will have to use the single filer tax table. This will likely increase my taxes substantially next year.
Also, because I no longer have to pay off debt each month I can add more funds to my emergency savings fund and use those funds to pay the tax bill when it comes due.
Do You Have a Propensity to Incur New Debt?
While I was married, I was afraid to pay off debt.
I actually did pay off our debt several times using personal loans.
The deal with my wife was that I would pay off the consumer debt with a lower interest loan if we agreed not to use the credit cards. We agreed, but as soon as the limit on the credit card was opened up, the money was spent.
I actually kept my credit cards as close to the limit as possible so that my wife wouldn’t be able to use them. This was a financial strategy we used!
Needless to say, it was not a good strategy. Instead of paying off our debt, I added cash to our emergency fund and had almost $30,000 saved when my wife and I separated.
If I didn’t trust myself not to incur additional debt, I would be less inclined to pull money from an inherited IRA (or any other savings account, for that matter), to pay off my consumer debt. Instead, I would just continue to work my monthly debt payoff plan.
But now that my wife and I are separated, I can control whether I will incur more debt. I am much more disciplined in my spending than my wife was, and intend to pay off my credit cards each month.
Why You SHOULD Use an Inherited IRA to Pay off Debt
I was about 90% certain that I should use my Inherited IRA to pay off my debt. But before I could pull the trigger, I decided to solicit some feedback from the ChooseFI community on Facebook.
Here was my post:
I have a question about my debt payoff plan. I’m using hypothetical numbers here.
I have $600,000 in retirement accounts, $100,000 of which is an inherited IRA (meaning no 10% withdrawal penalty, but I would have to pay income tax on the withdrawal).
I have a personal loan of $20,000 with a $1,300 monthly payment and 17 payments left. (10% interest) I have about $20,000 in high interest (20-30%) credit cards.
I am self-employed, so income varies somewhat. Fixed expenses are relatively low.
I’m currently putting all extra income each month towards debt to knock it out as quickly as I can, but it still may take 1-2 years to fully pay off. Once it is paid off, I plan to use what I was contributing to debt to max out my savings.
Not sure where I will land income-wise this year, likely in the 22 or 24% bracket. This has been a down year income-wise. I expect to earn more in 2025.
Debating whether to withdraw from the inherited IRA and pay off the debt or pay it off over time with excess earnings.
Mentally, I would love to have it paid off. This is marital debt I assumed in my divorce settlement, so the likelihood of me incurring more debt is very low. (I was always the frugal one!)
One last consideration – I received a rental property in the settlement that is rented until next August. I intend to sell this property when the tenant’s lease is up in 11 months and should receive about $100k in cash proceeds. So worst case, I can pay off all the debt from this money. However, there is a risk that property goes down in value or the tenant wants to stay another year (he is a family friend) so I don’t end up selling next year…
Am I completely stupid to even be thinking about paying off the debt with my inherited IRA?
TIA!
The results were undeniable. 85% of people that voted on this post indicated that I should pay off the debt using the Inherited IRA.
There were also some insightful comments, including this:
This just goes to show that money (and debt in particular) causes extreme emotions. And for me in particular, holding on to this debt was also holding on to the memory of my past life. And the commenter was absolutely correct – by paying off this debt I would be closing a difficult chapter in my life.
Final Decision… I Used My Inherited IRA to Pay off My Debt
Numerically speaking, this was not the smartest choice. It will ultimately cost me more money in the long run to pay off my debt with my inherited IRA.
But at the end of the day, I DID decide to pull $40,000 out of my inherited IRA and pay off my credit card debt and my personal loan.
And honestly? It felt amazing to pay those debts off. I’m so glad I did it.
