Calculating IRA Withdrawal Penalty

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diggs14
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Calculating IRA Withdrawal Penalty

Post by diggs14 » Fri Mar 03, 2017 11:19 am

I'm trying to show a family member the effect that early withdrawal penalties will have on their retirement. What is the best way to calculate it? I know there are several calculators online but I would prefer to be able to show it by hand. They are wanting to withdraw the minimum amount needed to cover their debt.

Current Balance: $200k
Tax Bracket: 25%
Early Withdrawal Penalty: 10%
Debt Balance: $75,000

Thanks in advance!

diggs14
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Re: Calculating IRA Withdrawal Penalty

Post by diggs14 » Fri Mar 03, 2017 3:29 pm

Also, is the tax applied to gains or the entire amount withdrawn?

DSInvestor
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Re: Calculating IRA Withdrawal Penalty

Post by DSInvestor » Fri Mar 03, 2017 3:53 pm

Assuming Traditional 401k or IRA with zero basis (non-deductible contributions), the entire withdrawal would be subject to Fed and state income tax as well as 10% early withdrawal penalty. Do they live in a state with income tax and does that state tax withdrawals from retirement accounts?

In order to cover 75K in debt, they'd have to withdraw at least 120K. On 100K withdrawal, they lose 11K to early withdrawal penalty and the 100K adds to their income which would be taxed at 25% Fed and some at 28% for the portion that breaks into 28% bracket.

120K - 12K penalty - 30K = 78K. This assumes all 120K is taxed at 25% rate.

If 60K is taxed at 25% and 60K taxed at 28%:
120K - 12K penalty - 15K - 16.8K = 76.2K.

Can this person stop reduce retirement contributions to increase take home pay?
Does the plan offer the option for a 401k loan?

diggs14
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Re: Calculating IRA Withdrawal Penalty

Post by diggs14 » Fri Mar 03, 2017 5:06 pm

This person is completely fine to continue paying on both the contributions and loan, but believes that all debt must be paid immediately even at the expense of withdrawing from the IRA :oops:. I've managed to build a spreadsheet showing cash flows per year and ultimately the opportunity cost of such a decision.

Just have had a little difficulty coming up with way to show the penalties incurred if they do take out the minimum amount to pay off all debt.

cherijoh
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Re: Calculating IRA Withdrawal Penalty

Post by cherijoh » Fri Mar 03, 2017 6:00 pm

diggs14 wrote:This person is completely fine to continue paying on both the contributions and loan, but believes that all debt must be paid immediately even at the expense of withdrawing from the IRA :oops:. I've managed to build a spreadsheet showing cash flows per year and ultimately the opportunity cost of such a decision.

Just have had a little difficulty coming up with way to show the penalties incurred if they do take out the minimum amount to pay off all debt.

Okay here is the way you would set it up in Excel assuming all the money gets taxed in the same 25% marginal tax bracket :

Amount needed $75,000.00 [B1]
federal tax bracket 25% [B2] <-- entered as a decimal; formatted as %
state tax bracket 0% [B3] <-- entered as a decimal; formatted as %
early withdrawal penalty 10% [B4] <-- entered as a decimal; formatted as %

amount withdrawn $115,384.62

Enter Excel Formula as = (B1*(1/(1-B4/(1-B2-B3)))*(1/(1-B2-B3)))

Enter my numbers to check that you get the same answer.

To deconstruct this, the 10% penalty on the amount withdrawn is $11,538.46 and the 25% tax on that same amount is $28,846.15 leaving you with $75K and a $0.01 rounding error (since I trimmed everything to 2 significant digits).

Edited to add BOTTOM LINE: The person in question must withdraw $40,384.62 EXTRA to net $75K and cover taxes at 25% plus the 10% penalty. It is even more if some of that gets pushed into the 28% bracket as I expect it would.

mhalley
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Re: Calculating IRA Withdrawal Penalty

Post by mhalley » Sat Mar 04, 2017 1:58 pm

Shouldn't you also calculate the loss of the gains over x years at y rate of return on the $115 thousand?

Dreday78
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Re: Calculating IRA Withdrawal Penalty

Post by Dreday78 » Sat Mar 04, 2017 3:51 pm

This literally just happened to my wife and me. We liquidated an IRA for a home purchase. When it was all said and done we paid a 10% penalty, the cash boosted our income so we were in the 33% tax bracket. For good measure we were hit with the Alternative Minimum tax as well. When it was all said & done it was around 44% of the money gone.

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jmndu99
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Re: Calculating IRA Withdrawal Penalty

Post by jmndu99 » Sat Mar 04, 2017 5:07 pm

OP, did this family member come to you for assistance with this debt dilemma?

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Epsilon Delta
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Re: Calculating IRA Withdrawal Penalty

Post by Epsilon Delta » Sat Mar 04, 2017 5:30 pm

diggs14 wrote:This person is completely fine to continue paying on both the contributions and loan, but believes that all debt must be paid immediately even at the expense of withdrawing from the IRA.
They clearly haven't believed this all along or they would not have $75,000 in debt. If you want to convince them the key is probably figuring out why they changed their mind. Perhaps their new guru would be as horrified as you are at the early IRA withdrawal.

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jimb_fromATL
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Re: Calculating IRA Withdrawal Penalty

Post by jimb_fromATL » Sat Mar 04, 2017 6:13 pm

diggs14 wrote:I'm trying to show a family member the effect that early withdrawal penalties will have on their retirement. What is the best way to calculate it? I know there are several calculators online but I would prefer to be able to show it by hand. They are wanting to withdraw the minimum amount needed to cover their debt.

Current Balance: $200k
Tax Bracket: 25%
Early Withdrawal Penalty: 10%
Debt Balance: $75,000

Thanks in advance!
The first problem is that taking out a chunk of money that big will often cause a lot of it to be taxed in a higher than normal tax bracket. Then the 10% penalty for early withdrawal makes it worse. Then the long-term loss of time for earning compound interest on the money that is no longer invested is much, much worse.

GIve us some details about their current top tax brackets for federal and state; their age; how much they're earning in their retirement accounts; and the rate and payments on the loan(s) and we can generate a custom report like this:

Here's an example that illustrates the problem -- for paying off a $75K debt.
  • If you have to pay an average of 25.% federal and 5% state income tax plus the 10% penalty for a total of 40% you'll have to withdraw $125,000. The taxes and penalty alone will cost $50,000, leaving $75,000 to pay down debts. You'll have to come up with that at tax time, and may even have to pay an extra penalty if you didn't pay it quarterly.

    Assuming you have about 5 years remaining on the student loans, the $75,000 at 6.8% would have cost about $13,681 interest.

    So you'd immediately pay 3.7 times more in taxes and penalties than you would have to pay in interest on the debt over the next 5 years.

    But the taxes and penalties are only the tip of the iceberg.

    If you had left that $125,000 alone to earn a fairly conservative estimate of 7% over perhaps 35 years until retirement , it could have grown to $1,438,269, earning $1,313,269 in interest.

    So you've given up $1,313,269 in potential earnings to save $13,681 in interest on the debt. That's 96. times as much interest lost than you save on the debt.

    But wait…that's not all.

    At a very conservative 4% earnings rate after retirement in 35 years, that extra $1,438,269 could have paid you a monthly annuity income of $6,867 per month for 30 years before it was all gone.

    So you've given up a potential retirement income of 360 x 6866.52 = $2,471,946 in order to save that $13,681 in interest on the loan.

    That's a lifetime loss of $180.68 for every dollar you save in interest on the debt.
If you could earn more nearly the long-term stock market averages, the lifetime loss could run into some real money.
  • If you could truly earn 12% like Dave Ramsey says 'anybody can earn in any good mutual fund' --both before and after retirement-- you would come up short by $8,163,699 at retirement, and be giving up a potential monthly income of 83,972.84 x 360 = $30,230,222 after retirement.

    So you would be giving up $30,230,222 to save $13,681 in interest on the loan. That a lifetime loss of $2209.59 for every dollar that you save on the debt if you make the early withdrawal now. (Thanks, Dave.)
When you're not in dire financial straits and can afford the payments, it does not pay to postpone or reduce contributions to retirement either.

Here are links to several threads where my posts show examples of how delaying retirement investing for earning compound interest plus paying taxes prematurely in order to pay down manageable debts too fast can cost anywhere from tens to hundreds of thousands to millions of dollars out of your future retirement income -- in exchange for saving only a tiny fraction as much interest on the relatively short term debts.

viewtopic.php?f=2&t=136151&p=2011928#p2011928 Student Loans and Retirement help
viewtopic.php?t=136385 Paying student loans vs Losing compounding interest
viewtopic.php?f=2&t=128788 Swamped In Debt - Thoughts?
viewtopic.php?t=131027 Advice when to start investing considering Student Loan Debt
viewtopic.php?f=2&t=129906 Mortgage PMI or Student Loan?
viewtopic.php?f=1&t=180529 Pay down mortgage or stuff retirement accounts?
viewtopic.php?f=1&t=178566 Mortgage or 401k

jimb

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jimb_fromATL
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Re: Calculating IRA Withdrawal Penalty

Post by jimb_fromATL » Sat Mar 04, 2017 6:33 pm

diggs14 wrote:I'm trying to show a family member the effect that early withdrawal penalties will have on their retirement. What is the best way to calculate it? I know there are several calculators online but I would prefer to be able to show it by hand. They are wanting to withdraw the minimum amount needed to cover their debt.

Current Balance: $200k
Tax Bracket: 25%
Early Withdrawal Penalty: 10%
Debt Balance: $75,000

Thanks in advance!
It occurs to me that another question in addition to their age is what kind of account(s) are holding the retirement money now.

You can virtually never withdraw money from a 401(k) or other employer-sponsored plan while you're still working there.

You can withdraw money from an IRA, but for tax-deferred plans theregular tax brackets or higher plus the 10% penalty apply if you're under age 59.5.

If it's a Roth IRA, you can withdraw the contributions (not the earnings) at any time without tax or penalty. But that still makes virtually no financial sense, because that still causes you to miss out on the once-per-year use-it-or-lose it opportunity to have that money invested in an account where it will be earning compound interest for the rest of your life tax-free.

I've never known of a single person who ever did this, but even if they had the personal discipline to reinvest every penny of the freed-up payments, they would run into limits on the yearly contributions that get any tax advantage. With the loss of time and tax advantage, it would take far more money than the freed-up payments to make up for the up-front loss. So for younger folks the loss of tax-advantage and TIme for earning compound interest can still run into tens to hundreds of thousands of dollars lost from probably future retirement income in exchange for saving only a tiny fraction as much interest on the debt.

jimb

pkcrafter
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Re: Calculating IRA Withdrawal Penalty

Post by pkcrafter » Sat Mar 04, 2017 6:49 pm

Anything here apply?


diggs:
They are wanting to withdraw the minimum amount needed to cover their debt.
Where did the debt balance come from? Emergency? Still working? Maybe they should stop contributions and direct money to the debt.
You may qualify to take a penalty-free withdrawal if you meet one of the following exceptions:

You become totally disabled.
You are in debt for medical expenses that exceed 7.5 percent of your adjusted gross income.
You are required by court order to give the money to your divorced spouse, a child, or a dependent.
http://www.401khelpcenter.com/401k_educ ... LtLOzjY-uI

401k loan

http://www.401khelpcenter.com/loans.html#.WLtOrjjY-uI




Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

diggs14
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Re: Calculating IRA Withdrawal Penalty

Post by diggs14 » Mon Mar 06, 2017 9:33 am

Okay here is the way you would set it up in Excel assuming all the money gets taxed in the same 25% marginal tax bracket :

Amount needed $75,000.00 [B1]
federal tax bracket 25% [B2] <-- entered as a decimal; formatted as %
state tax bracket 0% [B3] <-- entered as a decimal; formatted as %
early withdrawal penalty 10% [B4] <-- entered as a decimal; formatted as %

amount withdrawn $115,384.62

Enter Excel Formula as = (B1*(1/(1-B4/(1-B2-B3)))*(1/(1-B2-B3)))

Enter my numbers to check that you get the same answer.

To deconstruct this, the 10% penalty on the amount withdrawn is $11,538.46 and the 25% tax on that same amount is $28,846.15 leaving you with $75K and a $0.01 rounding error (since I trimmed everything to 2 significant digits).

Edited to add BOTTOM LINE: The person in question must withdraw $40,384.62 EXTRA to net $75K and cover taxes at 25% plus the 10% penalty. It is even more if some of that gets pushed into the 28% bracket as I expect it would.
I'll try plugging that in and seeing how it works. That seems to be around the number I guesstimated. Thank you!

To answer a couple of other questions, I believe it may have come from some type of podcast. They casually asked me my thoughts on the matter and I tried to explain as best as I could and that I would get back with them with more concrete numbers.


This individual is 39 and all the cash is in an IRA.

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