My understanding is that you would get to choose to either spread the tax burden (unpenalized) over three years, OR you could repay the funds over three years without taxation. Maybe I misunderstood?
If this is the case why wouldn't you do it? It just provides optionality. If you end up not retiring, or not wanting to keep the funds post tax, just repay the funds. If something happens where you would benefit by keeping the money out unpenalized, then you could.
Because if you don't need it there's no sense in doing it. Plus you will be paying more taxes.
Example of us. If we pull out the $100k. With our salaries this year, we would most likely be in the 22% bracket. So that $100k is taxed $22k.
If we tap into our 401k when we retire, we pay little to no taxes.
Using 2020 tax table. The first $25k is exempted. The next $10k is 10%. So if we can live on $35k when we retire, we only need to pay $1000 on the $10k.
If it is true you could repay it in 3 years without taxation, how would you be paying more taxes? That $100k wouldn't be taxed at $22k, it would be taxed at $0 as long as you put it back in time, at least if what Classical_Liberal says is true. So what's the downside in that scenario?
Let's say you take out $100k and put it in a taxable brokerage and invested it in the same way it was before, waited 3 years, then put $100k back in to the retirement account. And assume you are young enough that you still are below 59.5 at the end of those 3 years, and that the law says you won't be taxed at all for having that money out for those 3 years (no penalty, no tax). What is the result?
The result is no extra taxes paid, BUT the gains from that $100k are in your taxable brokerage account rather than your retirement account. That's a good thing! Money in non-Roth retirement accounts in BAD, it is much better off in a brokerage. The purpose of a non-Roth (pre-tax) retirement account is served at the moment you put the money IN. Once it is in, getting it out without paying tax ASAP is the goal!
Why do I say money in a 401k/tIRA is bad? Because ALL money you take out of those accounts is taxed as regular income, both gains and principal. But ONLY gains and dividends count as income when pulled from a brokerage account, AND those gains (and most dividends, if you just use total market index funds) are taxed at a favorable rate.
In fact, if married filing jointly you can claim up to $104,000 of qualified (long term) gains with 0% taxes if you had no other income (Standard Deduction + first $80k of qualified gains÷nds are taxed at 0%). So, if, say, half of your brokerage is gains and the other half principal, that means you could spend $208,000 in one year and pay nothing in taxes using a brokerage. Now go ahead and calculate how much $208k from a 401k/tIRA would cost you in taxes in a single year (and add an extra 10% if need it before 59.5!).
Even in your example, $35k / year of spending would cost you $0 in taxes if you got the money from a brokerage, which is still less than the small amount you'd pay for $35k / year spent from a 401k. The only account that could possibly do better is a Roth, and that's only if the tax laws change at some point so brokerage gains no longer get a favorable tax rate AND you don't need any of the gains in the Roth (just the contributions) until after 59.5. Even if the favorable tax rate goes away one day, since money from the brokerage is not likely to be 100% gains, you'd probably still end up paying $0 from a brokerage at your level of spending (since $35k of spending would likely be < $25k of gains for quite a long time, especially if you practice capital gains harvesting in the earlier years of retirement). Thus, a Roth is really only useful as a vehicle for getting money out of a traditional account without paying taxes, via a Roth Ladder (for as long as that is still legal to do).
The only potential problem I see with what Classical_Liberal proposed is that when you go to put that money back in year 3, you'll accrue gains from selling from the brokerage in order to put the money back into the retirement account, so if it say doubled in value than that's an extra $50k of gains to report that year, which might be a problem if you are in a high tax bracket from other income in that 3rd year. Otherwise, I see no downside to this if A) it is legal and B) it really does allow you to keep the money for 3 years with no taxes whatsoever as long as you put it back later (which I'm not convinced is true, I think you may have to pay taxes in the first 2 years you have it out, but we'll see what the IRS says - if it turns out it isn't true, you'll just need to put it back within 1 year instead of 3 so less gains going to the superior brokerage account).
