When Benefits of Cutting Debt Burden Outweigh Penalties for IRA Withdrawal

Q

I am a 48-year-old single man. A year ago I quit my job to take care of a terminally ill relative with whom I am living. His pension and savings cover my basic living expenses, but I have no direct source of income and consequently have been living on my credit cards.

The result is a $30,000 debt whose interest payments, at an average of about 18%, I can just barely cover each month. However, I could pay off my debt if I tapped into my Individual Retirement Account, which has a balance of about $600,000. It earns about 8% to 10% in interest each year. I have been reluctant to make a withdrawal because of the 10% penalty. I have borrowed money from my relative to make my monthly credit card payments. He refuses to lend me the money to pay off the cards because of the size of my IRA. What should I be doing?

--A.F.

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A You cannot wait for an inheritance or the lottery to take care of this problem. You must reverse your position on your IRAs, ASAP--if not sooner.

Here’s the shorthand version of our advice: It is unwise for you to be paying huge interest payments each month while sitting on a IRA as large as yours. And because you basically have no income for 1996 and because the year is drawing to a close, you are in an even better position to tap into your IRA before the end of the year to pay off about two-thirds of your credit card debt, leaving the remainder to pay off early next year with a second withdrawal.

Let’s walk through this reasoning with Margi Mullen, a Los Angeles financial planner. By tapping into your IRA now, you will have to pay a 10% federal penalty plus a 2.5% state of California penalty on any funds withdrawn, plus normal income taxes.

The trick, as Mullen sees it, is to keep your 1996 withdrawal large enough to make a dent in your debt but small enough to stay within the 15% federal income tax bracket. This maneuver takes maximum advantage of the fact that you have virtually no income for the year and of the year-end timing of a move to apply your IRA toward your debt.

According to Mullen’s calculations, you should make a $30,000 IRA withdrawal before the end of the year. Of that, $3,750 will go toward the penalty. Next, figure on setting aside about $5,000 for federal and state income taxes on your withdrawal. This leaves you with $21,250 to apply toward your credit card balance, which should make a huge dent in the amount you must pay (and consequently borrow from your relative) each month. Early next year, you can tap into your IRA to cover the remaining debt, plus applicable income taxes and penalties.

At the bottom of this reasoning is Mullen’s belief that you are unwise to be paying 18% in interest on your credit card debt while maintaining an IRA like yours.

You might wonder whether you would be better off to tap into your IRA through an annual amortization option, which would avoid the 12.5% federal and state penalties.

However, amortization requires you to make withdrawals in even annual amounts for five years or until you turn age 59 1/2, whichever occurs later. In your case, you would be required to make the withdrawals for the next 11 years. And given the size of your IRA, the amount of your annual distributions (calculated according to your life expectancy) would clearly put you in at least the 28% tax bracket--it could be higher yet if you reenter the work force. In favoring just two withdrawals (with penalties), Mullen argues that there’s no point in exposing yourself to a long-term cure if the short-term one can do the job.

Finally, and just because I can’t resist an opportunity to preach against carrying credit card debt, I want to impose a penance on you. Every night, as your cheek hits the pillow, just whisper: “Chronic credit card debt is bad. Chronic credit card debt is bad. Chronic credit card debt is bad.”

Home Sale Requires IRS Notification Q My mother is incompetent and I am her conservator. I sold her home for $55,000. Her only income is a small Social Security benefit. Do I have to file an income tax return on the sale of the home?

-- S.F.

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A Although your mother’s income is apparently below the threshold for paying income taxes, she, through you, must still file a tax return with Form 2119, the form on which you report the details of a sale of a personal residence.

Tax Bite for Sale of Stock Within Year Q What are the advantages or disadvantages of selling a stock at a profit before holding it for one year?

-- L.C.

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AAlthough there has been much talk of changing the capital gains tax structure, the law currently stands that gains on assets held for less than one year are taxed as ordinary income to the holder under federal rates that could be as high as 39.6%. Gains on assets held for more than a year are similarly subjected to taxation as ordinary income, with one important difference: The maximum tax bite is 28% regardless of the holder’s income tax bracket.

What this means is that taxpayers in the higher (above 28%) income brackets are subject to a bigger tax bite when selling assets held for less than one year.

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Carla Lazzareschi cannot answer inquiries individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053 Or send e-mail to carla.lazzareschi@latimes.com