Will I still come out ahead with the 10% early withdrawal penalty?

[aes421]

Hi all,

I have hit the tipping point where I have enough in my 401k for 60-90 and must decide where to store my FI-60 stash.  My plan has always been to start investing a brokerage account like MMM did, but I have since started reading about tax avoidance strategies, specifically Roth IRA Conversion Ladders.

I have a while before I FIRE so my fear is that Congress would close that loop hole and I wouldn't be able to get my money out. 

However, then I started thinking if it comes to it I can withdraw 24k and pay 0% income tax + 10% penalty.  That is far less than the 22% tax bracket I'm in right now.  Even if I needed a little more than that I would be paying 10% income tax + 10% penalty for a total of 20%.

Does that sound right or am I missing something?

Thanks in advance

[secondcor521]

Generally correct.

If you want to be more thorough in your analysis, you would consider all tax effects, not just federal income.  State income taxes should be considered, although considering those probably results in the same conclusion.  FAFSA EFC and ACA subsidy effects could come into play if you have kids in college or plan to use the ACA marketplace for health insurance.

Then there is sensitivity analysis to potential changes.  You're MFJ now; what if you suffer a divorce or death?  The tax rate is 24% now, what if it goes up (or down)?

I'm not saying you're wrong, I'm just saying you could consider the additional factors listed above if you want to.

[DadJokes]

Why do you have to take a 10% penalty?

There are multiple ways to access retirement accounts early

[RWTL]

You're correct - and don't forget that by having your money invested at the pre-tax rate, the money that would have been taxed is also growing.

That said, you may be able to have your cake and eat it too....the link above may help.  Also, check out the Madfientist's blog.  He looked into the exact question you are asking and came up with a similar conclusion.

[DK]

interested to hear other thoughts on this, but yeah once i ran the numbers and looked at things, to me it made more sense to take the penalty + tax and pay the 20%, rather than try to build a 5yr conversion strategy paying 22% on that money.

[GoCubsGo]

@DK
I'm curious, did you move up your FIRE timeline and didn't have enough of a cushion in taxable or cash to sustain spending those 5 years of the conversion ladder?  I'm a bit concerned as I'm too heavy in 401K/IRA's and with the huge market run up I'd be able to retire much quicker than I planned just 4 years ago but probably won't have a 5 year runway in cash or taxable.

[DeniseNJ]

But you already paid taxes on Roth money so this would be 10% on top of that.  It's not just 10% on your gains, it's on the entire withdrawal, isn't it?  I think you're underestimating the total tax on that money.

[MustacheAndaHalf]

There are no taxable gains in a Roth account - the money is all after-tax, with restrictions on withdrawal.  In a Traditional IRA, all of the money is pre-tax, so you owe taxes on 100% of the withdrawal.

OP, can you give a "time until retirement", and "time before 60 in retirement"?

For example, if you're retiring soon and reaching 60 soon, that favors investing in taxable.  Each year, you'd get ~2% dividends and probably owe 15% tax, or roughly 0.3% tax (of the total).  And your gains would be modest, so the tax paid on withdrawal would also be modest.  But both of those costs increase over time, so the timing matters.

[seattlecyclone]

interested to hear other thoughts on this, but yeah once i ran the numbers and looked at things, to me it made more sense to take the penalty + tax and pay the 20%, rather than try to build a 5yr conversion strategy paying 22% on that money.

This is absolutely the correct comparison to make. Will you get to keep more of your money if you pay tax on it now or later? The early withdrawal tax is meant to tilt the incentives away from making these withdrawals and toward other options instead, but it can still work out that the early withdrawal is the cheapest option.

Furthermore it doesn't have to be an all-or-nothing decision. You don't have to choose between paying early withdrawal tax on 100% of your "early" withdrawals forever, or doing five years worth of Roth conversions prior to retirement. Another option is to take the penalty the first year of retirement while also making enough Roth conversions up to the top of whatever tax bracket you end up in. Do the same the next year and the next and a few years down the road you'll have enough Roth basis that you won't need to make as many direct withdrawals from the traditional IRA.

Also make sure to consider the effect that ACA phase-outs will have on your marginal rate in retirement. If you're planning to buy health insurance through your state's ACA exchange during retirement with an income below 400% of the poverty level, the phase-out of ACA tax credits acts as an additional 10-18% tax. Add the base federal tax rate and a 10% early withdrawal tax to this number and it's less likely that this ends up being cheaper than making a few extra Roth contributions during your working years.

[DK]

@DK
I'm curious, did you move up your FIRE timeline and didn't have enough of a cushion in taxable or cash to sustain spending those 5 years of the conversion ladder?  I'm a bit concerned as I'm too heavy in 401K/IRA's and with the huge market run up I'd be able to retire much quicker than I planned just 4 years ago but probably won't have a 5 year runway in cash or taxable.

@GoCubsGo eh, maybe just bad planning? I figured in 1-2 years i'd be ready so got a more in depth on numbers, and the whole ACA/health costs threw me a bit for a loop. yearly spend would put me out of range for any ACA help, which would greatly increase my yearly spend, so increase FIRE date quite a bit. my plan now is to eliminate the mtg, which is roughly 900/month so decrease yearly spend a good amount, and put me in a better ACA range. so that would also reduce spend from it seemed about 10k/yr to 1k/yr. then it's kinda, do i want to save 125Kish for 5yr pipeline paying 22% on it, or just start taking 25K withdrawals paying 20%...

[DK]

Also make sure to consider the effect that ACA phase-outs will have on your marginal rate in retirement. If you're planning to buy health insurance through your state's ACA exchange during retirement with an income below 400% of the poverty level, the phase-out of ACA tax credits acts as an additional 10-18% tax. Add the base federal tax rate and a 10% early withdrawal tax to this number and it's less likely that this ends up being cheaper than making a few extra Roth contributions during your working years.

i've read that article before, and honestly the graph confuses me....it seems to be saying i'm better off at the 300% than 200% range? from what i've kinda saw, it seems the lower the better?

[seattlecyclone]

Also make sure to consider the effect that ACA phase-outs will have on your marginal rate in retirement. If you're planning to buy health insurance through your state's ACA exchange during retirement with an income below 400% of the poverty level, the phase-out of ACA tax credits acts as an additional 10-18% tax. Add the base federal tax rate and a 10% early withdrawal tax to this number and it's less likely that this ends up being cheaper than making a few extra Roth contributions during your working years.

i've read that article before, and honestly the graph confuses me....it seems to be saying i'm better off at the 300% than 200% range? from what i've kinda saw, it seems the lower the better?

The graph is of marginal rates: how much your cost increases as your income increases. The higher your income the more you'll pay, but once you hit 300% your premiums will increase slower than they did in the 200-300% range.

[DK]

Was thinking a bit more about this over the weekend. I think some of it depends on timeframe, and I might have to take back my initial thoughts...in my case taking the penalty instead of spending a few more yrs working to build up a pipeline will result in me locking in that 10% penalty for 20ish yrs, instead of paying a slightly higher tax rate on the pipeline funds for a few years, and eliminating the 10% penalty. Someone nearer to retirement would probably be fine taking the penalty (or maybe doing a SEPP). For longer timeframe it would probably be worth paying 22% for 5 yrs on normal income to lock in 15yrs at 12%, rather than pay 20% for 20yrs.