Reader Lisa recently contacted me with a really tough question. With her permission, I’m sharing her question with you.
Be kind to her, she’s human, and she can’t turn back the clock and do things differently. She needs help dealing with her current situation, so please give your honest opinions. She knows that we’re not all personal finance experts around here, but she’s hoping that some frugal-minded folks may have some ideas for dealing with her difficult financial situation.
” My hubby and I have had all our ducks lined up in a row and both live frugally and have been able to sock away over $150K in IRA’s over the years (we are 37 & 39 with 3 kids under 5). The only debt we owe is our mortgage and 2 student loans. Anyway, my risk seeking husband opened his own business 6 years ago which is now in the process of dissolving. We are protected personally by the corporation for anyone coming after us, but we did personally guarantee the line of credit for $180,000 as well as the business credit card for $32,000. Since the business is out of money we think this will all fall on our shoulders.
“My question is, do we pay the fees and penalties to cash in our IRA’s to help pay this off (as much as we hate to do that) or should we try to take out a second mortgage and really be in over our heads? I know this is complex and was curious if you had any thoughts or suggestions? I appreciate your input.”
I asked Lisa a few follow up questions to find out more information: They owe about $283,000 on their home which they refinanced in 2010 at a 5.3% interest rate. She’s a stay-at-home mom who does some part-time work one day a week to bring in extra money (about $2,000/year). The business has not brought in any money since February and they are currently living off their emergency fund. They do receive an additional $11,000 each year in dividends from an investment that they have.
My limited knowledge of withdrawing money from an IRA is this: Because they are not 59-1/2 and do not have any qualifying circumstances, they will pay a 10% penalty on the amount they withdraw. The amount they withdraw will also be subjected to income tax (and they’re in the 25% bracket). They will also pay state income taxes, too at a rate of 7.05%.
So whatever they withdraw from the IRA, they’ll have a whopping 42.05% taken from. If they withdraw $100,000 from their IRA, they’d really only have $57,950 to apply to their debt. They would lose $42,000 in the deal, it wouldn’t cover the debt, AND, they would have nothing saved for retirement.
My gut reaction says to leave the IRA alone. With all of the penalties and taxes involved, it just wouldn’t be worth losing all of that money.
My gut also says to avoid the second mortgage. Getting a large second mortgage (which may be hard to do when there is no income coming in) would most likely put their house under water. If they had any more blows to their finances (i.e. unable to find a job, medical issues, etc), they wouldn’t be able to sell the house for a profit, and they could lose the house.
So what options does that leave Lisa and her husband?
The first thing I would do is start negotiating with the bank and the credit card company. They won’t let you off the hook for what you owe, but you may be able to reduce the amount you owe or get better interest rates. I would also do some research to find out if you can find any wiggle room in the terms of their student loans.
I would also suggest that they both start looking for work. Daycare costs for 3 kids would eat up too much take-home pay, so my approach would be that whoever finds a decent job first takes it, and the other parent stays home with the kids. The parent at home would need to be the chief home economist – cutting expenses wherever they could and finding ways to make extra income on the side. Don’t add any more debt, and keep current with all payments.
Consider selling the house. If they have enough equity in their house, they may be able to pay down the debt that way. While it would not be fun to live with three small children in an apartment or rented house, it is doable, especially if it means financial solvency. Consider selling a car or other assets (just be watchful of any taxes you may have to pay on the sale of these assets).
And finally, even though it hurts me to say it, I think Lisa and her husband should consider meeting with a reputable bankruptcy attorney to discuss options. A qualified attorney would be able to help them figure out what course of action they could take that would have the least impact on their future. Unless Lisa and her husband are able to negotiate their debt down significantly, it may be the only real viable option for them.
So readers, I’ll turn it over to you. Please help Lisa out: