I was actually thinking of making a post with essentially the same question!
Even paying the 10% penalty is better than taxable.
Can someone explain this with numbers? Because I've been trying to do reading and that's not really sinking in. I'd like to understand it rather than just taking someone's word for it. My husband was asking why not just invest in a mutual fund outside of a 401k/IRA to avoid having your money be locked up for years and I didn't really have an answer.
If your marginal tax rate is 25%, and you expect to have a 15% marginal tax rate (or less) in retirement, then it works out like so, assuming you start with $10k and withdraw when it doubles:
IRA/401k: you invest $10k now. Later, you withdraw $20k, pay $2k in penalties, and pay no more than $3k (15%) in taxes. You walk away with $15k
Traditional: you pay 25% in taxes now, invest $7500. Later, you withdraw $15k and pay zero taxes
In both scenarios, you end up with the same amount of money. But let's take a more real-world example, say of $40k withdrawal per year. Then the numbers for the IRA/401k look like this:
$40k withdrawn
-$20.7k standard deduction and personal exemptions (assuming married filing joint, no kids)
---------
$19,300 in taxable income.
The first $18550 (in 2016) would be taxed at 10%, and the last $650 would be taxed at 15%. That gives you a total tax bill of about $1950. Add that to the 10% penalty for early withdrawal, and you're looking at a take-home of about $34000. The amount you pay to Uncle Sam is about 15%.
Let's assume that the $40k you originally withdrew started as a $10k investment that doubled twice, and back-calculate how much you'd have to invest via traditional investments in order to get that same take-home:
$34k/4 = $8500 original investment
$8500/(1-.25) = $11,333 (add back in the 25% taxes you paid)
In other words, you'd need to take more money from your paycheck now to get that $34,000 payout later if you opt for a traditional investment rather than a 401k/IRA. This all assumes, however, that you're well into the 25% tax bracket. If you're already in the 15% or 10% bracket now, then a traditional investment will make more sense.