10% penalty (401k) vs tax accounts

[MoonLiteNite]

I have seen several people on this forum state that it is better to just take 10% penalty (from 401k) then putting your money in tax accounts.
Anyone care to explain when that would actually be the case. From my few attempts to verify it. It seems like a tax account is still better.

[seattlecyclone]

Suppose you're in the 28% tax bracket while you're working and you plan to be in the 15% tax bracket during retirement. If you put your money in a taxable brokerage account you'll pay 28% on it this year, and then 15% on dividends every year until you retire. Alternatively you could put it in your traditional 401(k), withdraw what you need when you retire, and pay 15% regular tax plus a 10% early withdrawal tax for a total of 25%. 25% is less than (28% + dividend taxes).

[cmublitz]

I think way more people advocate doing the 5 year Roth IRA conversion ladder or 72t SEPP than paying a 10% penalty to withdraw 401K funds.

[dandarc]

I think way more people advocate doing the 5 year Roth IRA conversion ladder or 72t SEPP than paying a 10% penalty to withdraw 401K funds.

Yes, but seattlecyclone makes the point that even if you have to pay it, you don't always come out behind.  So if you're in the 25% or higher tax bracket, it is likely you'll come out even or ahead even if you have to pay the 10% additional tax. 

Therefore, in this scenario you should prioritize all tax-advantaged accounts ahead of all taxable accounts when accumulating.  Assuming your spending is such that you won't go beyond the 15% bracket when drawing down.

You'll do even better if you can execute a Roth Ladder or SEPP withdrawals, so just pointing out the margin of safety of the "Max that 401K" strategy.

[seattlecyclone]

Indeed, the Roth ladder is great if you can make it work. However I sometimes see people ask if they should quit contributing to their traditional 401(k) so they can instead focus on building a big enough taxable account to last for the first five years of retirement. The answer is that sometimes paying some amount of early withdrawal tax for the first five years can be better than paying tax at a high rate now just to avoid paying the 10% later.

The best situation is to be able to max out your traditional 401(k) and save some in a taxable account, but if you can't do both you should figure out which one has the lowest tax rate. Sometimes that could involve paying early withdrawal taxes! The word "penalty" (which the IRS never uses for this purpose, by the way) causes people to irrationally avoid it. This is unfortunate. Just remember it's a valid option and consider it accordingly.

[frugalnacho]

Suppose you're in the 28% tax bracket while you're working and you plan to be in the 15% tax bracket during retirement. If you put your money in a taxable brokerage account you'll pay 28% on it this year, and then 15% on dividends every year until you retire. Alternatively you could put it in your traditional 401(k), withdraw what you need when you retire, and pay 15% regular tax plus a 10% early withdrawal tax for a total of 25%. 25% is less than (28% + dividend taxes).

Not only that, but the entire amount will be able to compound in the 401k in the mean time.  So even in a scenario where you actually pay higher taxes upon withdraw because of the extra 10% you still probably come out ahead. 

[VladTheImpaler]

I had a similar question:
Is it still best to max a 401k even if employer does not doing any matching for the first 2 years?

Specifically:
Employer matching contributions are made at 25% of the deferred contribution up to 6% after second employment anniversary.

[dandarc]

Usually you have to have a really terrible 401K - front loads, very high ERs, that sort of thing, for taxable to be better than the 401K.  For example, I have a solo401K - no match that doesn't come from my own pocket, and yet I still do it.  Why?  Because it saves a boatload in taxes, and the funds I've chosen aren't terrible.

But do your own math / post more details if you want a better answer.

[moof]

Suppose you're in the 28% tax bracket while you're working and you plan to be in the 15% tax bracket during retirement. If you put your money in a taxable brokerage account you'll pay 28% on it this year, and then 15% on dividends every year until you retire. Alternatively you could put it in your traditional 401(k), withdraw what you need when you retire, and pay 15% regular tax plus a 10% early withdrawal tax for a total of 25%. 25% is less than (28% + dividend taxes).

Also consider state income taxes.  If you plan to retire to a lower state income tax state, or if your state has progressive taxation like California does it further reinforces the advantages.  I am in Oregon now, and in the 9% state tax bracket, which is about close to the highest rate around as it gets for any state and is very non-progressive.  If I put it in a taxable account now I lock in paying the high state taxes forever.  Putting it in a 401k allows me to potentially reduce or avoid that 9%.  So if I retire to Nevada I would go from a 25+9% tax rate to a 15+0% tax rate, which even makes an early withdrawal penalty a clear winner compared to taxable.

If you went the other way, taxable starts being about equal.  25+0% accumulating in Nevada and retiring to Oregon at 15+9% are roughly equivalent in buying power after the dust settles.

If you are really rich you maintain a residence in WY for tax purposes and live wherever you want, but not all of us get to make enough money that a whole residence is cheaper than just paying taxes where we actually live.

[fattest_foot]

I'm a bit dubious on the advantages of the conversion ladder unless changes are made to ACA subsidies in the next few years.

Jacking your income up to take full advantage of tax free conversions means paying significantly more for health insurance.

[seattlecyclone]

I'm a bit dubious on the advantages of the conversion ladder unless changes are made to ACA subsidies in the next few years.

Jacking your income up to take full advantage of tax free conversions means paying significantly more for health insurance.

The tax-free conversions are only up to the amount of your personal exemptions and itemized/standard deductions. If you don't have at least that level of income, you're probably going to be on Medicaid. Once you get up to the income level where you do get a subsidy, the premium subsidy phaseout acts as a 2-9.5% tax, depending on income level. This factor is definitely worth considering, but don't place a higher weight on it than it deserves.

[dandarc]

I'm a bit dubious on the advantages of the conversion ladder unless changes are made to ACA subsidies in the next few years.

Jacking your income up to take full advantage of tax free conversions means paying significantly more for health insurance.

The tax-free conversions are only up to the amount of your personal exemptions and itemized/standard deductions. If you don't have at least that level of income, you're probably going to be on Medicaid. Once you get up to the income level where you do get a subsidy, the premium subsidy phaseout acts as a 2-9.5% tax, depending on income level. This factor is definitely worth considering, but don't place a higher weight on it than it deserves.

Thanks for stating that so clearly.  You should pimp your blog over the forum threads on the whole 10% additional tax and ACA topics - you've written the clearest and completest articles on both those topics I've seen.

[DrF]

I'm shocked no-one has linked madfientist article covering this exact question.
http://www.madfientist.com/how-to-access-retirement-funds-early/

According to the scenario run by MadFIentist, your 3 best options for withdrawing money from a tax advantaged account are (in order of best to least best): SEPP, then Roth ladder, then 10% penalty (are all better than investing in a Roth or taxable account). The difference between the best (SEPP) and worst (Penalty) to withdraw from a tax advantaged account is a net worth difference of ~4.82%, and only ~2.7% less than the Roth ladder. Even if you take the 10% penalty when you withdraw from your tax advantaged account, your net worth is still ~33% greater than what would have been in a Roth after 15 years of withdrawals.

[moof]

I'm a bit dubious on the advantages of the conversion ladder unless changes are made to ACA subsidies in the next few years.

Jacking your income up to take full advantage of tax free conversions means paying significantly more for health insurance.

I'm similarly running numbers for the whole picture at retirement.  In particular I will have 6 years of my mortgage left after retirement if all goes according to plan, requiring about $20k of extra withdrawals (plus extra for taxes) for those 6 years.  I'll take a hit of about $3k of subsidies a year lost versus refinancing (if rates stay put) for 30 years to spread out the withdrawals.  Conversely I want to minimize withdrawals during the college years so the kiddo can max out grants and such, and I am just starting to figure out how to estimate those.  We might just downgrade to whatever our equity will get us and be done with it.

My head ends up spinning at all the scenarios and which accounts to draw down when to maximize college aid and ACA subsidies.  I now better understand why people become desperate enough to hire financial planners to tell them what to do, something I really used to think was a complete waste of money.  I could easily waste/lose many thousands of dollars getting it wrong, or getting bad advising.

[fattest_foot]

I definitely don't want to hire a financial advisor, but a CPA is something I'm leaning towards for maybe the year or two prior to retirement, and year or two after.

It seems like those will be the ones where there's a high variability in income (going from high income to low) that may have big tax implications that I don't take advantage of, or plan for correctly. I see how GoCurryCracker manages their taxes, and while I understand the concepts, I feel like I'm not as confident as they are.