I think we’ve covered this in brief before, but it’s a common – and, easy to make – mistake, so I thought that I should cover it again, here …
… Diane asks:
I’m withdrawing the funds in the IRA to pay [some of my] debt. So, is my Net Worth actually decreasing?
Unfortunately, that’s not the case; simply moving money between accounts (such as using some spare cash to pay down your home mortgage) doesn’t do anything to change your Net Worth, at least not on its own …
… it seems counter-intuitive, so try updating your NWiQ profile by, say, taking $10k from your retirement account and reducing one of your debts by the same amount … you’ll quickly see that your Net Worth does not change.
Here’s an example:
Let’s assume that Diane currently has a Net Worth of $66k because she has some assets (including a $93k ‘retirement account’) totaling $259,500 but she has to pay debts (liabilities) of $193,000 (including a $33k credit card debt).
Now, let’s see what happens if she takes $10k out of her Retirement Account to help knock a hole in her expensive credit card debt (let’s also assume there are no taxes or other penalties involved):
All that’s happened – from a purely Net Worth perspective – is that the Retirement Account has gone down $10k (to $83,000), but so has the credit card debt (from $33,000 down to ‘only’ $22,000). Do the math and it’s clear:
Diane’s Net Worth hasn’t changed … it’s still $66,000!
What will change is that Diane will earn less in her retirement account, but she will save more interest on her debts. I’m betting that paying the debt down (thus saving, what, 10% – 20% interest p.a.?) will put more money into her pocket than the 6% – 10% that she is ‘losing’ in long-term mutual fund returns (after fees and charges) …
… and, it’s what Diane does with THAT ‘found money’ that will dictate what happens to her future Net Worth 🙂
She may end up losing a lot in taxes and penalties if this is a standard IRA and she isn’t 59 1/2… I don’t know enough specifics to calculate her actual losses but I have seen calculations that come out as high as %40 for taking money out of a 401K, that makes 10-20% interest seem tame!
If it is a Roth IRA- she is unlikely to have taxes or penalties but has the opportunity cost of the tax free compound growth.
We won’t really know how much that is until she retires… but it could be fairly large. With a Roth IRA she can choose her investments and get index funds with expenses as low as 0.1% yearly. Let make a conservative estimate… say she retires in 20 years and a low cost index fund returns 7.9% after expenses:
10,000*(1.079)^20 = $45,753 tax free.
Granted that inflation will erode the purchasing power, but I suspect it would have the purchasing power of at least $20K today.
Same as rolling credit card debt into a heloc, nothing has changed, you simply moved the debt. When I was in debt I thought about many ways for it to disappear, I just paid it with my cash flow
Yeah this is just a situation that requires ‘income’.