Potential Consequences of Taking IRA Distributions to Pay Off Debt
Once there is no longer a paycheck, retirees will typically meet expenses with a combination of social security, withdrawals from retirement accounts, annuities, and pensions. Social security, pensions, and annuities are usually fixed amounts, while withdrawals from retirement accounts could fluctuate based on need. This flexibility presents opportunities to use retirement savings to pay off debt; but before doing so, it is important to consider the possible consequences.
Clients often come to us saying they have some amount left on a mortgage and they would feel great if they could just pay it off. Lower monthly bills and less debt when living on a fixed income is certainly good, both from a financial and psychological point of view, but taking large distributions from retirement accounts just to pay off debt may lead to tax consequences that can make you worse off financially.
Below are three items I typically consider before making a recommendation for clients. Every retiree is different so consulting with a professional such as a financial planner or accountant is recommended if you’d like further guidance.
Impact on State Income and Property Taxes
Depending on what state you are in, withdrawals from IRA’s could be taxed very differently. It is important to know how they are taxed in your state before making any big decision like this. For example, New York State allows for tax free withdrawals of IRA accounts up to a maximum of $20,000 per recipient receiving the funds. Once the $20,000 limit is met in a certain year, any distribution you take above that will be taxed.
If someone normally pulls $15,000 a year from a retirement account to meet expenses and then wanted to pull another $50,000 to pay off a mortgage, they have created $45,000 of additional taxable income to New York State. This is typically not a good thing, especially if in the future you never have to pull more than $20,000 in a year, as you would have never paid New York State taxes on the distributions.
Note: Another item to consider regarding states is the impact on property taxes. For example, New York State offers an “Enhanced STAR” credit if you are over the age of 65, but it is dependent on income. Here is an article that discusses this in more detail STAR Property Tax Credit: Make Sure You Know The New Income Limits.
What Tax Bracket Are You in at the Federal Level?
Federal income taxes are determined using a “Progressive Tax” calculation. For example, if you are filing single, the first $9,700 of taxable income you have is taxed at a lower rate than any income you earn above that. Below are charts of the 2019 tax tables so you can review the different tax rates at certain income levels for single and married filing joint ( Source: Nerd Wallet ).
There isn’t much of a difference between the first two brackets of 10% and 12%, but the next jump is to 22%. This means that, if you are filing single, you are paying the government 10% more on any additional taxable income from $39,475 – $84,200. Below is a basic example of how taking a large distribution from the IRA could impact your federal tax liability.
As you can see, taking the extra distribution to payoff debt added $9,003 to your federal tax liability. Yes, you had additional income so it makes sense your tax bill is higher, but this shows that you are paying at a rate 10% higher than you possibly ever would have. If you are giving the bank 3-4% interest each year it is usually better than giving the government an extra 10%.
How Will it Impact the Amount of Social Security You Pay Tax on?
This is usually the most complicated to calculate. Here is a link to the 2018 instructions and worksheets for calculating how much of your Social Security benefit will be taxed ( IRS Publication 915 ). Basically, by showing more income, you may have to pay tax on more of your Social Security benefit. Below is a chart put together with information from the IRS to show how much of your benefit may be taxed.
To calculate “Combined Income”, you take your Adjusted Gross Income + Nontaxable Interest + Half of your Social Security benefit. For the purpose of this discussion, remember that any amount you withdraw from your IRA is counted in your Combined Income and therefore could make more of your social security benefit subject to tax.
Peace of mind is key and usually having less bills or debt can provide that, but it is important to look at the cost you are paying for it. There are times that this strategy could make sense, but if you have questions about a personal situation please consult with a professional to put together the correct strategy.
Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.