Life might put us into sticky financial situations that require the need for cash. If you are working, though, getting cash from your tax-deferred savings is too costly to you – even when you are forced to retire early. Find the money somewhere else.
Tax-deferred savings include IRAs, 401(k)s, and comparable retirement-oriented savings plans. They are designed for retirement, and, consequently, carry penalties together with taxes for cashing them in when you retire early. Since they’re tax deferred, whatever you withdraw from them are taxed at your normal tax bracket. And in the event you haven’t reached age 59½, you will pay a 10% withdrawal penalty on top of the federal and state income tax. (There’s an exception: in the event you retire early, you can tap business programs like your 401k with out an early withdrawal penalty).
Although you will pay tax on these distributions whenever you retire, taking an early retirement withdrawal while you’re still working (or in the year when you have had earned income) creates much more loss than you might think. The reason is that your withdrawal gets added on top of your other income potentially forcing you into a higher tax bracket and causing your overall tax to be more. Additionally, you lose the future tax-deferred growth you’d get on that cash.
Pricey Example
Let’s assume you’ll need $20,000 for your first year of early retirement. Let’s also assume you are single and have earned $83,000,000 for the year in which you decide on early retirement.
In the year you go for early retirement, say you’ve earned $83,000 so that any additional income you get is in the 28% tax bracket (2011 federal tax tables). And whatever you take out of a tax-deferred account such as an IRA, is handled as ordinary income – and piled on top of your $83,000.
Now if you want $20,000 to spend after taxes, you need to take out more to cover the tax on the withdrawal. And here’s the kicker. It’s not 25% more, but 28% because the extra income jumps you into the next tax bracket. So you need to withdraw $27,778 to pay the federal tax and have $20,000 to spend. The situation would be much worse if you are under age 59 1/2 (age 55 if withdrawing from a 401k) and if you live in a state with state income tax.
The table also demonstrates the financial cost of making withdrawals from tax deferred savings. You notice that getting money from an IRA or 401k can be very costly.
| Tax Loss for Early Retirement Withdrawal on a Tax-Deferred Account |
||
| Amount needed | 28% bracket | 28% and under 59 1/2 (w/10%penalty) |
| $20,000 | $27,778 | $32,258 |
| Excess withdrawal as percent of $20,000 | 38.9% | 61.1% |
If you need cash to retire, borrow it – from your home equity, a friend or from a regular financial institution. It is cheaper doing this; and also you can pay it back later- when you fully retire and your income tax rate is much lower.
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