Did I Give The Right Advice? – Real Life Situation

I think this is going to become a new series for me. At least until friends stop telling me about their financial issues.

I gave a friend some advice yesterday. I am not sure if it was the 100% proper advice, but I think it was good. Keep reading and let me know.

Real Life Situation

$2,000 in IRA
($10,000) in credit card debt at 4.3% interest (24 month introductory rate)

Should she take the money in her IRA out and pay off some of the debt.

Other things to consider: She is currently paying down the debt an extra $500 a month. My guess is that it will be 15 months and they will be debt free.

My Advice

I told my friend that she should either not touch her IRA or consider converting it to their Roth if they were annoyed that it was sitting in a traditional IRA. I thought that completely pulling it out was a bad idea because of the 10% penalty for pulling funds out of an IRA.

She responded to this advice “it would only cost $200 to pay off $1800 in debt”. While technically correct, I rephrased it for my friend. I said, “if it was $200 for $1,800 or $200K for $1.8M, it shouldn’t make a difference. 10% is 10% and thinking like an economist, the person should try to optimize every dollar they have or will receive.

So how did I do? Is this what you would have advised?

12 Responses to Did I Give The Right Advice? – Real Life Situation
  1. Mike Piper
    March 18, 2010 | 6:00 am

    She’d also have to pay ordinary income tax on the withdrawal since it’s a traditional IRA. It doesn’t make much sense to pay a 10% penalty to pay off 4.3% interest debt.

    The question of whether or not to convert to a Roth is separate. It mostly comes down to a) does she have cash on hand to pay the tax on the conversion and b) does she expect to be in a higher tax bracket in retirement than she’s in now?

  2. Brian
    March 18, 2010 | 6:03 am

    @Mike – Ah yes. I did mention the tax implications in my advice. Forgot to include that in the post. I assume the taxes would be paid by short changing the credit card debt a little bit further.

  3. Aaron @ Clarifinancial
    March 18, 2010 | 6:21 am

    She’d be paying $200 (plus tax) to pay off her debt 3-4 months earlier. I wonder what that would make her effective interest rate if she included the penalty and tax with the amount she’s already paying in interest? 6.5-8% something (depends on income tax bracket and me using a calculator.)

    She might wind up doubling the money she gives away and doesn’t get back just to pay a bill a few months early. Not to mention the opportunity cost of not being invested – that alone would make me want to ride 4.3% a lot longer.

  4. Chris
    March 18, 2010 | 6:23 am

    I think you did the right thing advising her to not touch the IRA money. She could take a 10% loss and then get a 4.3% return on her money; I think this nets to 5.9% loss? (0.90 * 1.046) By leaving it in the IRA and invested you’ll (hopefully) get a positive return and everyone always assumes the market will go up around 8%. Even if she keeps the money in a CD earning 1% she’ll still be doing better than -5.9%. If the rate on her debt were higher, say 29.99%, THEN she’d be doing right by liquidating and paying off. (11.1% is breakeven if my math logic is correct)

  5. Stephen P
    March 18, 2010 | 6:38 am

    As an economist, I welcome you into our fraternity of numbers-worship. Your hall-pass is good for 24 hours. Enjoy it. Hayek and Keynes are battle-rapping at 7

    And yes, I agree completely with your advice. Touching the IRA is not only bad mathematically, it is bad psychologically. If she taps savings to pay off debt now, could that start a habit where she taps her 401K in 10 years?

  6. me in millions
    March 18, 2010 | 7:01 am

    Agreed. I’ve always been taught that retirement money should not be touched ever. And especially not to pay down debt. I also just learned that if the IRA is through her job and she gets fired, she is required to pay back the loan in full within 1-2 months of her termination. Bad move.

  7. Moneymonk
    March 18, 2010 | 11:57 am

    How about she just work and pay off the $10,000

  8. Abigail
    March 18, 2010 | 9:17 pm

    I think you absolutely gave the right advice. Even without considering the tax penalty, she’s looking at taking money out of an account that she may not repay. It’s easy for other things to come up and delay putting the money back.

    It’s best to work toward retirement a little at a time while being responsible about credit card payments. For example, we put only $100 a month in the bank, but at least we’re starting. And once we’re out of debt, I’ll increase the amount.

  9. JoeTaxpayer
    March 19, 2010 | 7:48 am

    What is her marginal tax rate? That would help answer the conversion question.

    If the card rate were 18-24% I might feel differently, but under 5%? Don’t touch IRA unless marginal rate is 15% or less and convert it.

    You answered right. You should even be questioning this, it’s not even close to a tough decision.

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