Wealth gives us the freedom to make big purchases like a home, cover unexpected emergencies like long-term illness, take a sabbatical to spend time with family, or bootstrap starting a business.
However, for many, a significant portion of our wealth sits in retirement accounts. Have you considered withdrawing funds from your 401(k) or IRA for a major purchase or life event? It's tempting, especially when facing the unexpected. Some say you should never touch your retirement funds, but in certain situations it could make sense.
🧠What you need to know
If you're a regular reader of The Boost, you know we’ve often spoken about how fees and taxes can impact your long-term wealth. Taking money out of your retirement accounts can be costly. If you dip into your traditional 401(k) or IRA before age 59½, there's a 10% early withdrawal penalty. You'll also owe income taxes on the amount you withdraw, which can significantly increase the total cost.
Consider this: if you withdraw $10,000 early, you could end up paying $1,000 as a penalty plus your marginal tax rate on the withdrawn amount. If you're in the 22% bracket, that's an additional $2,200 in taxes, totaling $3,200, or 32% of your withdrawal, in penalties and taxes.
However, Roth 401(k)s and IRAs operate differently. Contributions (not earnings) can be withdrawn tax-free and penalty-free at any time because you've already paid taxes on those. In other words, if you contributed $10,000, you can withdraw $10,000 anytime.
đź’ˇ The exceptions
The IRS allows penalty-free withdrawals for some qualified expenses, but you’ll still be responsible for ordinary income tax. Some exceptions include:
- Medical expenses: Unreimbursed medical expenses over 7.5% of your adjusted gross income.
- First-time home purchase: Up to $10,000 can be withdrawn penalty-free from an IRA.
- Higher education expenses: Penalty-free withdrawals are allowed for qualified higher education expenses for you, your spouse, children, or grandchildren.
- Disability: If disabled, you can make penalty-free withdrawals.
- Substantially Equal Periodic Payments (SEPP): Both 401(k)s and IRAs allow penalty-free withdrawals under SEPP programs, following specific IRS rules.
Does it make sense outside of the exceptions?
Let’s evaluate the tradeoffs and if it could make sense for you to make an early withdrawal.
Why not start with your taxable brokerage account?
You may also be saving in a standard brokerage account outside of your retirement accounts. How do you evaluate withdrawals from a taxable vs. a retirement account? Imagine your taxable account has investments that have appreciated significantly, resulting in potential capital gains of $50,000 if you sold $100,000 of stock. At a 20% long-term capital gains tax rate, selling could cost you $10,000 in taxes. If these are short-term, you’d pay the ordinary income tax rate. Let’s say you’re in the 24% bracket, then you would face $12,000 in taxes.
Alternatively, withdrawing from an IRA could trigger both income tax and a 10% penalty if you're under 59½. If you're in the 24% tax bracket, selling stocks worth $100,000 and withdrawing from an IRA could result in $24,000 (24%) in income taxes plus a $10,000 penalty, totaling $34,000 in taxes and penalties. That’s roughly three times the taxes incurred when selling from a taxable account, assuming no penalty exception.
401(k) loans
Suppose you consider taking a $25,000 loan from your 401(k) instead of an early withdrawal. If repaid according to plan rules, typically within five years, there are no taxes or penalties on the amount. You will have to pay interest on the loan; the rate is typically the prime rate plus 1% - 2%. If you leave your job, you should pay back your loan; otherwise, it will be treated as an early withdrawal. The maximum you can take as a loan is the lesser of $50,000 or 50% of your vested balance. This option requires a stable employment situation and confidence in your ability to repay, but it may be a good alternative for you.
Large retirement savings, high post-retirement taxes
This may seem like a long ways off, but after age 73, you will be required to take distributions from your retirement accounts. Let’s say you are 32 years old have $500,000 in your Traditional IRA. If your account tracks a market average appreciation of 8% per year, your IRA would be worth over $10M by age 72. Your required minimum distributions would be approximately $420K, potentially putting you in the 35% tax bracket. Taking early distributions from your IRA could make sense if you can get to a lower post-retirement bracket.
Converting to a Roth IRA
Converting a traditional IRA to a Roth IRA results in the converted amount being subject to income tax, which might deter some. However, if you anticipate being in a lower tax bracket in a particular year—perhaps due to a career break or reduced income—converting during such times could offer long-term tax advantages. This is because Roth IRAs benefit from tax-free growth, and qualified withdrawals, including earnings, are tax-free. Therefore, it could be easier to tap into savings in a Roth IRA account if needed. However, it's important to note the IRS mandates waiting five years after the conversion to make tax and penalty-free withdrawals of converted funds.
Note: Before making one of the above moves, consult your accountant to make sure you’re making the optimal decision for your tax bracket.
🤝 How can Mezzi help?
Before making a decision about how to fund a large financial need, you need to account for all of your investments. How are you going to know which assets to sell and from which accounts? Getting organized is key.
This week, Mezzi is launching a new feature to make it easy to quickly understand, monitor, and manage your family’s allocation to taxable and retirement accounts. This is in addition to existing capabilities:
- Estimated tax exposure
- Consolidated and account-level realized and unrealized gains and losses
- Consolidated and account-level asset allocation
