We have recently received several calls from clients and radio show listeners who also have accumulated sizable credit card debt. Their questions are twofold: should they pay off the debt with other assets and, if so, where to withdraw the assets from to pay off that debt.
Our first request is always that they specify the outstanding balance of each specific card (assuming there is more than one) and the interest rate being charged by each lending institution. The second consideration revolves around the financial resources available to tap into should the decision be made to pay down or pay-off the balances on the cards.
Both tax ramifications and the reduction of liquidity must be considered.
The most appropriate manner to help consumers regarding credit card debt is to create several scenarios and outline our recommendation to each situation. Each scenario assumes that the client has credit card debt that they wish to eliminate through tapping into other available sources.
First — a reminder: The average interest rate being charged by credit card issuers is well in excess of the long-term historical normal return of the stock market (10%). Also, outside of utilizing credit cards for business purposes, interest charged by the lending institutions are not tax deductible.
Scenario 1: Assumes credit card debt of $10,000 owed by an individual or couple who are approximately 45 years of age. They currently have sufficient equity in their home to pay-off their credit cards via a home equity loan and have balances in an employer sponsored pension plan such as a 401(k) or 403(b) plan.
We recommend the client withdraw the balance owed from their home equity loan and set themselves up on a payment schedule not to exceed five years. This course of action is encouraged because of the lower interest rate offered by a home equity loan compared to credit card issuers. In addition, the interest charged for the home equity loan is tax deductible, while the interest charged by the credit card company is not.
Regardless of the age of the client, we generally recommend tapping the home equity rather than creating a taxable situation that would result from a client withdrawing funds from an Individual Retirement Account (IRA) or other qualified investment. The only exception would apply to clients who have reached the age where they must take mandatory distributions from their IRA. In this case, it’s often quite feasible to use these withdrawals rather than home equity.
Scenario 2: Assumes credit card debt of $10,000 owed by an individual or couple who are approximately 45 years of age. They currently have sufficient equity in their home to pay off their credit cards via a home equity loan, have balances in an employer sponsored pension plan such as a 401(k) or 403(b) plan and have non-qualified accounts (taxable brokerage accounts or mutual funds).
We recommend this client withdraw the balance owed from their non-qualified accounts to satisfy the credit card debt. The money should be pulled from the areas of these accounts that have the least potential for growth, namely money market funds and/or bond funds. In fact, generally speaking, regardless of the age of the client, this course of action is preferable to others.
(One note: be certain to re-balance your portfolio back to your intended percentages)
Scenario 3: Assumes credit card debt of approximately $10,000 owed by a retired individual or couple and who are approximately 65 years of age. They currently have sufficient equity in their home to pay-off their credit cards via a home equity loan, have balances in an IRA, but have no other assets. Also, they do not have sufficient monthly income to pay for the debt. Once again, we suggest a home equity loan to satisfy the credit card debt.
However, this does not eliminate the cash flow issue. So we generally recommend a client in this situation withdraw money from their IRA to pay the monthly home equity charges, but amortize that loan over a five year period. This will reduce the tax burden resulting from the IRA withdrawal, while potentially benefitting from the interest deduction from the home equity loan.
There are dozens of potential scenarios, these three are the most common. Apply your own situation appropriately or give us a call to help you understand yours.
One note of caution: should you pay off all credit card debt only to build it back up, then our plans will not work.
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial advisor. Please note that Fagan Associates, Inc or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial advisor prior to making any changes to your portfolio. To contact Fagan Associates, Please call (518) 279-1044.
