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When it's OK to fund your IRA with a credit card

If you're in debt and in a low tax bracket, this isn't a wise move

By Beverly Harzog

After being on the economic equivalent of "Mr. Toad's Wild Ride" this past year, you might be coming up a little short on cash when it comes time to funding your IRA. This is a big problem if you were counting on contributing the maximum amount and getting a tax deduction for 2008.When it's OK to fund your IRA with a credit card

As crazy as this initially sounds, you might consider funding your IRA by using a cash advance on your credit card. This approach can be a little risky, but in the right circumstances, you might actually make a profit. Whether this makes sense for you depends on a couple of things:

1. The type of IRA matters
First, it depends on what type of IRA you have. If you have a Roth IRA, you're funding it with after-tax dollars. There's no tax deduction involved, so funding your Roth IRA with a credit card doesn't make sense.

If you're one of the 37.5 million households in the United States who own a traditional IRA, though, you're funding your account with pretax dollars. "Typically, this strategy works best if it's a traditional IRA where you can get a deduction and you're also in a high enough tax bracket to offset the cost of borrowing on your credit card," says Lee Rosenberg, a certified financial planner in Jericho, N.Y.

2. Your tax bracket matters
For the 2008 tax year, if you're 49 and under, you're allowed to contribute $5,000 to your IRA; if you're 50 and over, you can contribute $6,000. The tax savings really add up as your tax bracket climbs. Here's how much you'll save if you use a credit card to temporarily fund a $5,000 IRA contribution: 

Tax savings from funding $5,000 IRA with credit card

Income

Tax bracket

Tax savings

Net tax savings
if paid in full
after two months*

Net tax savings
if paid in full
after 12 months*

Less than $16,050

10%

$500

$251

($199)

Between $15,005 & $65,100

15%

$750

$501

$51

Between $65,100 & $131,450

25%

$1,250

$1,001

$551

Between $131,450 & $200,300

28%

$1,400

$1,151

$701

*Includes $150 credit card fee plus minimal monthly payments of $125 with 12 percent interest using CreditCards.com's credit card calculator.

Is your cash-flow problem only temporary?
Funding your IRA with a credit card is risky, but if you're expecting an influx of money -- and waiting for a rich uncle to die doesn't count -- then this is a viable option to consider. Maybe you're waiting on a sales commission check or a bonus in the next few months. Or you've loaned money to someone and the loan is due next month. "If there is a short-term cash crunch and you knew the credit card would be paid off within the next three to nine months, then it could be an option, but I would be very cautious about it," says Robert Schmansky, a certified financial planner in Detroit.

Most financial experts warn against taking this plan too far. Even if you still make money by spreading the cost out over 12 months, that doesn't mean you should do it. "It only makes sense if you pay off the debt quickly," says Jeff Stouffer, a certified financial planner and a chartered financial analyst in San Francisco. "Otherwise, I think it could contribute to a short-term attitude toward investments."

Look at the numbers carefully
Research by the Investment Company Institute shows that the "typical" IRA owner makes $75,000 a year. Let's say you're 48 years old and you contribute the maximum $5,000 to your IRA. In this case, you pay taxes on $70,000 instead of on $75,000. You're in a 25 percent tax bracket, so your estimated tax savings is $1,250 ($5,000 x .25).

If you get the $5,000 as a cash advance from your credit card, you'll pay around a $150 fee. According to CreditCards.com, the national average for credit card interest was hovering around 12 percent in early February 2009.

Here's your net tax savings if you take two months to pay off the debt:

Net tax savings if you take two months to pay off the debt

You borrow:
$5,000
Your tax refund: $1,250
Less credit card fee:
$150
Less interest:*
$99
Net savings
$1,001
*Based on results using the credit card calculator on CreditCards.com, you'd pay $99 in interest charges if you made payments of $125 each month before paying back the rest of the balance in a lump sum. You've still saved a total of $1,001, plus you've added $5,000 to your IRA fund.

Even if you spread out the debt over 12 months, you come out ahead:

Net savings even if you take 12 months to pay off the debt

Tax savings:
$1,250
Credit card fee: $150
Interest:
$549
Net savings: $551

Another way to view this is to think about how much money you're actually paying back on the $5,000 that you borrowed. Let's take a look at the numbers if you pay the $5,000 back in two months:

Another way to look at the numbers when paying back in two months 
You borrow:
$5,000
Less tax refund: ($1,250)
Plus interest ($99) and fees ($150):
$249
Net amount you have to pay back:* $3,999

*Your savings are $5,000 minus $3,999, which equals $1,001

How's your risk tolerance?
In this economy, putting money in your IRA is not exactly a risk-free proposition. We've all had to get a little more comfortable with the ups and downs of the stock market. Before you take that cash advance, though, you need to be comfortable with your financial situation and be able to handle the uncertainty. There are really two parts to this: the amount of risk you're comfortable with and the amount of risk you should take. 

Are you going to have sleepless nights if that check you're expecting is delayed by four months? If so, then pass on this approach. If you're used to the roller-coaster ride of the market and the prospect of misjudging this situation won't break your budget or mess with your sanity, then consider it.

The amount of risk you should take is a little different. "If you're young and won't need the funds soon, you can consider moving your IRA funds into something more long-term and stable, like a CD," says Schmansky. If you're getting closer to retirement, though, you have less time to recover from a financial mistake. You also may not want to tie up your money in long-term CDs.

When in debt, don't try it
If you currently have a balance on your credit card that you're paying interest on, then this option is not for you. "This is not a strategy for those who aren't used to paying off credit card debt in a timely manner," says Rosenberg.

See related:  Invest using credit cards? It's both unavailable and unwise, CreditCards.com payoff calculator

Published: March 3, 2009


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