Early IRA withdrawal vs 401k loan for legal bills
- neurosphere
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Early IRA withdrawal vs 401k loan for legal bills
Hi all, posting for friend. The short summary is this:
Friend has legal bills from a recent divorce and ongoing custody disputes, and needs approx $20,000 in extra cash to get through the process (obviously a rough guess).
Option 1) Take a distribution from an IRA and pay income taxes and 10% penalty. I assume 25% tax bracket (no state income tax), but could be 15%.
Option 2) 401k loan. Has stable job, loan fees etc are reasonable.
With that limited information, doesn't it seem that the 401k loan would be preferred? Friend would have a chance to avoid the 10% penalty and income taxes, provided she was able to pay the loan over time, not lose her job, etc.
My friend only asked me for help filling out an IRA distribution request form (e.g. how to decide how much to withhold) but I know she has money in the 401k, and I am thinking to suggest to her to research into a 401k loan instead. So I wanted to see if there were strong opinions here about this, and I was thinking I could also suggest she check out this thread so she could read some opinions besides mine.
Thoughts?
Friend has legal bills from a recent divorce and ongoing custody disputes, and needs approx $20,000 in extra cash to get through the process (obviously a rough guess).
Option 1) Take a distribution from an IRA and pay income taxes and 10% penalty. I assume 25% tax bracket (no state income tax), but could be 15%.
Option 2) 401k loan. Has stable job, loan fees etc are reasonable.
With that limited information, doesn't it seem that the 401k loan would be preferred? Friend would have a chance to avoid the 10% penalty and income taxes, provided she was able to pay the loan over time, not lose her job, etc.
My friend only asked me for help filling out an IRA distribution request form (e.g. how to decide how much to withhold) but I know she has money in the 401k, and I am thinking to suggest to her to research into a 401k loan instead. So I wanted to see if there were strong opinions here about this, and I was thinking I could also suggest she check out this thread so she could read some opinions besides mine.
Thoughts?
- Taco Knight
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Re: Early IRA withdrawal vs 401k loan for legal bills
We'd need to know if it's a traditional IRA or a Roth IRA.
A Roth IRA lets one withdraw their contributions without penalty (aside from the hit on savings/planning, but this seems like a necessary loss for this isolated occurrence), whereas any early withdrawal from a traditional IRA prior to age 59½ is subject to being included in gross income plus a 10 percent additional tax penalty.
A Roth IRA lets one withdraw their contributions without penalty (aside from the hit on savings/planning, but this seems like a necessary loss for this isolated occurrence), whereas any early withdrawal from a traditional IRA prior to age 59½ is subject to being included in gross income plus a 10 percent additional tax penalty.
Re: Early IRA withdrawal vs 401k loan for legal bills
In a true emergency I would say the loan is better than the distribution.
- neurosphere
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Re: Early IRA withdrawal vs 401k loan for legal bills
Sorry, the IRA is a traditional IRA and this would be an early withdrawal.Taco Knight wrote:We'd need to know if it's a traditional IRA or a Roth IRA.
A Roth IRA lets one withdraw their contributions without penalty (aside from the hit on savings/planning, but this seems like a necessary loss for this isolated occurrence), whereas any early withdrawal from a traditional IRA prior to age 59½ is subject to being included in gross income plus a 10 percent additional tax penalty.
- Taco Knight
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Re: Early IRA withdrawal vs 401k loan for legal bills
Thought as much because you mentioned the penalty, but just wanted to be absolutely certain. I'd do the loan -- the space can be paid back, rather than the money being both hypothetically and actually lost.neurosphere wrote:Sorry, the IRA is a traditional IRA and this would be an early withdrawal.
Re: Early IRA withdrawal vs 401k loan for legal bills
The loan might make more sense than a withdrawal, but consider the financial consequences if she is unable to repay it for some reason, especially taxes and penalties. I would consider almost any other alternative in this particular situation.
- jimb_fromATL
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Re: Early IRA withdrawal vs 401k loan for legal bills
Insufficient data.neurosphere wrote:Hi all, posting for friend. The short summary is this:
Friend has legal bills from a recent divorce and ongoing custody disputes, and needs approx $20,000 in extra cash to get through the process (obviously a rough guess).
Option 1) Take a distribution from an IRA and pay income taxes and 10% penalty. I assume 25% tax bracket (no state income tax), but could be 15%.
Option 2) 401k loan. Has stable job, loan fees etc are reasonable.
With that limited information, doesn't it seem that the 401k loan would be preferred? Friend would have a chance to avoid the 10% penalty and income taxes, provided she was able to pay the loan over time, not lose her job, etc.
My friend only asked me for help filling out an IRA distribution request form (e.g. how to decide how much to withhold) but I know she has money in the 401k, and I am thinking to suggest to her to research into a 401k loan instead. So I wanted to see if there were strong opinions here about this, and I was thinking I could also suggest she check out this thread so she could read some opinions besides mine.
Thoughts?
Assuming her plan allows 401(k) loans, then she can only borrow up to half of the balance of the 401(k) loan ... so the first question is whether she has that much in the account.
Next question is whether she can afford the probably around $370 +/- payment for the 401(k) loan for five years.
If she can afford the payment, then the next question is whether she has adequate credit and can borrow the money from her bank or credit union. If money is tight, it would even be worth getting a loan a normal for a longer time with a lower payment from her credit union or bank.
Next, how much is she contributing to the 401(k) ?
...And if she can afford the loan, can she do it without having to stop making contributions to the 401(k)?
Assuming she can afford the payments, then borrowing the money would be better than cashing out the IRA. A normal lending insitution loan would be better than the risk of the 401(k) loan, as well as being better than the loss for cashing out the IRA.
The interest paid out to a normal lender would probably not be much if any more than the taxes and penalty on the early withdrawal. But the long term loss of compound interest and tax advantage on the money she took out including the tax and penalty would be far worse than the interest on the institution loan.
That may not be a problem in this case. She's guaranteeing to pay the taxes and penalty and lose all the compound interest for the rest of her life if she cashes out the IRA. But if she can afford to make the payments on the 401(k) loan she will still have the money in the IRA plus will eventually rebuild most of the 401(k).Pajamas wrote:The loan might make more sense than a withdrawal, but consider the financial consequences if she is unable to repay it for some reason, especially taxes and penalties. I would consider almost any other alternative in this particular situation.
If she loses her job and can't pay back the 401(k) loan within about 30 to 60 days, in most cases it will count as an early withdrawal, with the taxes and penalty and loss of compound interest. But even if that happens the long term consequences won't be any worse than she will be guaranteeing to lose by cashing out the IRA. Plus, she may have paid some of it back, which would reduce the long term loss, too.
Here's an example that illustrates how much less it will cost to borrow the money from a lender -- even at fairly high rate --compared to cashing out the IRA.
- If you have to pay an average of 25% federal and 0% state income tax plus the 10% penalty for a total of 35.% you'll have to withdraw $30,769 in order to pay the taxes and penalty of $10,769 and have $20,000 left to pay the expenses.
A bank or credit union loan for 5 years for $20,000 at perhaps 6.% would have a payment of $387 per month and would cost about $3,199 interest.
So you'd immediately pay 3.4 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 still only the tip of the iceberg.
If you had left that $30,769 alone to earn a fairly conservative estimate of 7% over perhaps 30 years until retirement , it could have grown to $249,738, earning $218,969 in interest.
So you've given up $218,969 in potential earnings to save $3,199 in interest on the debt. That's 68.4 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 30 years, that extra $249,738 could have paid you a monthly annuity income of $1,192 per month for 30 years before it was all gone.
So you've given up a potential retirement income of 360 x 1192.29 = $429,224 in order to save that $3,199 in interest on the loan. That's a lifetime loss of $134.16 for every dollar you save in interest on the debt.
In summary:
Best choice, borrow the money from an institution like a bank or credit union;
Next lesser of two evils, borrow from the 401(k) so you won't lose the tax advantage forever;
Last choice, cash out the IRA and guarantee to lose a huge amount of money over the rest of your life.
jimb
Re: Early IRA withdrawal vs 401k loan for legal bills
Hi Jimb, do you mind explaining how you calculated the tax and penalty of $10,769? I've never had to do an early withdrawal from the 401k so I don't quite understand how you reached that figure.jimb_fromATL wrote:
If you have to pay an average of 25% federal and 0% state income tax plus the 10% penalty for a total of 35.% you'll have to withdraw $30,769 in order to pay the taxes and penalty of $10,769 and have $20,000 left to pay the expenses.
jimb
Neurosphere, the 401k loan is better than the IRA withdrawal. And perhaps also even better than borrowing from a bank. The money you borrow from a bank results in interest paid to a third party, whereas the "interest" paid on a 401k loan simply goes back to your friend, i.e. she is paying herself that interest. The substance of both transactions are very different. The 401k loan is guaranteed to increase your tax-protected space. In fact, if the stock market tanks at any point between now and the repayment of the 401k loan, your friend will have done very, very well, because the 6% (or whatever the plan loan rate is) guaranteed return she pays to herself will outperform a 10% or 20% decline in the market.
If your friend has the option of borrowing from a Roth 401k, that is even better. This is because the interest component of your loan repayment to the 401k is double-taxed, whereas for a Roth 401k, it isn't. In a 401k loan, you use after-tax money to repay your principal, which is fine, because you've already gotten the upfront deduction once (with your original contribution). But the interest component uses after-tax money (no deduction), and yet you are taxed on it again when you withdraw. With a Roth 401k, you are contributing after-tax interest, but you won't be taxed on the interest and its earnings when it is eventually withdrawn.
- jimb_fromATL
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Re: Early IRA withdrawal vs 401k loan for legal bills
Just to clarify, this is about an early withdrawal from an IRA. You cannot arbitrarily withdraw cash from a 401(k) if you're still working at that company.Caduceus wrote:Hi Jimb, do you mind explaining how you calculated the tax and penalty of $10,769? I've never had to do an early withdrawal from the 401k so I don't quite understand how you reached that figure.jimb_fromATL wrote:
If you have to pay an average of 25% federal and 0% state income tax plus the 10% penalty for a total of 35.% you'll have to withdraw $30,769 in order to pay the taxes and penalty of $10,769 and have $20,000 left to pay the expenses.
jimb
If you need $20,000 in a hurry but don't have it and need to cash out your IRA to get it; and if your top tax brackets are 25% for the feds and 0% for state plus 10% penalty for early withdrawal, that's a total of 35% tax.
20000/(1-0.35) = $30,769.23 pre tax.
as a doublecheck:
30769 x 35% = $10,769 tax and penalty
30769-10769 = $20,000 net.
If you took out just $20,000 to pay the bill, you'd owe 20000 x 35% = $7000 in taxes and penalty at tax time.
If you took it today, you'd have 9 months to set it aside by next year's tax deadline. That's roughly $778 per month.
You'd need to pay quarterly estimated taxes or else have that much more withheld from your regular salary to avoid a potential penalty for under-withholding.
If you could afford an extra $778 per month out of your budget, all the more reason to borrow the money instead of taking it out of your IRA, since the interest on the loan is still only a fraction of the taxes and penalty, and the loss of compound interest for the rest of your life will still be mind-boggling.
Also bear in mind that the person here does not have a state income tax, which would make it worse. And a lot of folks taking out $20K plus enough money to pay the taxes might end up paying an even higher tax bracket percentage on some of the money.
jimb
- neurosphere
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Re: Early IRA withdrawal vs 401k loan for legal bills
Thanks for the information and discussion everyone.
I had not really considered a recommendation that she simply take out a personal loan. I'm not sure of her credit score and borrowing ability (I assume it's fine however). I think merely stating that taking out a loan is preferable to cashing out the IRA will emphasize the severe negative consequences of IRA withdrawals. I assume she (like many) has debt phobia due a life of fiscal prudence, and now finds herself in a tight spot, and that using "her own" money (via the IRA, for example) feels better than borrowing.jimb_fromATL wrote:In summary:
Best choice, borrow the money from an institution like a bank or credit union;
Next lesser of two evils, borrow from the 401(k) so you won't lose the tax advantage forever;
Last choice, cash out the IRA and guarantee to lose a huge amount of money over the rest of your life.
- jimb_fromATL
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Re: Early IRA withdrawal vs 401k loan for legal bills
Here are a few of the huge number of results that come up on a web search for "reasons not to borrow from a 401k"neurosphere wrote:Thanks for the information and discussion everyone.
I had not really considered a recommendation that she simply take out a personal loan. I'm not sure of her credit score and borrowing ability (I assume it's fine however). I think merely stating that taking out a loan is preferable to cashing out the IRA will emphasize the severe negative consequences of IRA withdrawals. I assume she (like many) has debt phobia due a life of fiscal prudence, and now finds herself in a tight spot, and that using "her own" money (via the IRA, for example) feels better than borrowing.jimb_fromATL wrote:In summary:
Best choice, borrow the money from an institution like a bank or credit union;
Next lesser of two evils, borrow from the 401(k) so you won't lose the tax advantage forever;
Last choice, cash out the IRA and guarantee to lose a huge amount of money over the rest of your life.
Pitfalls of a 401k loan
401k loan may cost more than you realize
5 reason not to borrow from your 401k
Eight Reasons To Never Borrow From a 401k
Top 10 reasons you should never
... though there can be some reasonably good reasons.
4 good reasons
--more--
Even if you don't lose your job and suffer the disaster of having to pay the tax and penalty as an early withdrawal -- along with the long term loss of compound interest earnings on the money that will never be in the 401(k) again -- you'll typically lose a lot more earnings from the 401(k) than you would pay in interest on an institutional loan.
In normal times --especially with 5 year loans (or longer)-- you're more likely to earn more compound interest in a 401(k) than you're paying yourself back on the 401(k) loan. Even if you don't reduce contributions while you're paying the loan, the incremental payments going back to your account are not likely to earn as much as the lump sum would have earned if you had never touched it.
To illustrate the problem:
- Suppose you could get a personal loan at a credit union for $20,000 at 6.% for 60 months. The payment would be $386.66. The total interest would be $3199.
If you left the entire $20,000 lump sum in a 401(k) earning an average of 7% it would grow to $28,353 in 60 months earning $8,353 interest .
If you borrowed $20,000 from your 401(k) and paid yourself back at 4.% over 60 months the payment would be $368.33.
Assuming the payments are reinvested immediately in the funds in the 401(k) and earn the same average of 7%, the $368.33 payment per month will give you $26,370 in your account after 60 months, earning $4270 interest. That's $1983 less than if you had not taken the loan.
You earned $4082 less interest but you're only short by about $1,983 in the 401(k) because you made up the difference out of your own pocket as interest on the 401(k) loan ... with money that would otherwise have been paid as interest to the lender.
Here's the bigger problem:
Assuming the same farly conservative average 7% earnings for perhaps 30 more years until retirement, the $1983 deficit will grow to $16,095.
Assuming the same 7% earnings, and 30 more years until retirement, the $26,369 would grow to $214,024.
But the $28,352 you'd have if you had left the 401(k) alone would grow to $230,119.
So at retirement time you come up with $16,095 less money in the account -- in exchange for saving $3199 in interest on the debt.
But wait...there's more.
Earning a more conservative 4% after retirement, that $16,095 could pay you $77 per month for 30 years before it was all gone.
So if you lived for 30 more years, you could lose 360 x $77 = $27,662 of future retirement income.
If you were to earn more nearly the long term stock market averages over a few decades, the long term loss would be considerably worse.
jimb