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The Dreaded Tax Penalty On Early Distributions From Retirement Accounts

If you have a work 401k, 403b or an IRA, then you have money which you set aside in these account before paying income taxes on them. In order to have access to these funds, you must either reach the age of 60, according to the IRS, or you must pay a 10% penalty on the early distribution.

This is one of the commonly cited reasons why people believe they cannot gain access to their retirement accounts early, prohibiting them from pulling the trigger on either early retirement or doing something more worthwhile with the money.

The discussion as to whether you should or shouldn’t cash out a retirement account is best left for another post. If anyone says that it’s always bad to cash out a retirement account then they likely don’t have anything but a very fundamental understanding of investing and retirement. That said, I have twice cashed out my retirement account for completely the wrong reasons.

Understanding Retirement Accounts

Briefly, a retirement account refers to an account which meets certain IRS guidelines and allows you to save away money without paying taxes no it. That tax will then later be owed when you withdraw the money upon reaching age 59.5. These are often referred to as qualified accounts. 

Fortunately, most physicians work full-time, well into their 60’s and so there are certain loopholes for outliers, such as myself, to exploit in order to gain access to my retirement funds in a cost-effective manner.

When you reach age 60 you can start withdrawing money from your retirement account and any income from it would be taxed on a federal and state level just as if you were earning that money through an employer.

However, you would not owe FICA taxes, also called payroll taxes, comprised of medicare and social security. Why? Because you already paid those when you contributed that money to that retirement account.

 

10% Tax Penalty – Why, Oh Why?

I highly doubt that the majority of the population would be invested in any kind of mutual fund, whether stocks or bonds if it wasn’t for the tax savings offered by retirement accounts. People don’t understand these things and generally are timid about trusting their money to a bunch of wall streeters.

However, the gov’t and the big financial institutions decided that it’s a worthwhile profitable endeavor for people to continue investing in these investment types and that’s how retirement accounts have maintained their footprint on our tax code.

Since we reduce our taxes by deferring taxation on retirement contributions, we are essentially getting a tax-break from the IRS – that’s how it is viewed by the public. And the money gets to grow tax-free – which is sort of true but sort of not – it’s technically true but not functionally.

Functionally, if your money grows in value, let’s say, 50% over a couple of decades so that a $100k investment becomes $150k, you will owe more taxes than you would have paid on that $100k during your working years. After all, the IRS now gets to tax the extra $50k as well.

What about that 10% tax penalty? It’s sort of the IRS’s way of slapping your wrist for accessing your accounts early. Congress doesn’t think you know any better and you have no way of proving them otherwise – yes, even top ranking economists and my CFP have to pay that 10% tax penalty on early distributions before age 60.

 

Understanding Finance Lingo

The financial industry is very technical, and so some of the terms they use can confuse rationally minded individuals. For example, our incomes are reported in gross terms. I earned $300k in 2012 – or my buddy earned $75k in 2014. Well, in fact, that was our gross earning and not at all representative of our total income.

If I grossed $300k and set aside $50k in retirement accounts, and had itemized deductions worth $25k then I got taxed on $225,000. Which means I paid $100k in taxes – gone, not earned, not saved. What I ended up with is $175,000 – so that’s what I earned. Telling people I earned $300k would be wrong, off by about 42%!

Dr. Mo, how much money did you earn in 2012? $300k…I mean, $175k. Or actually, wait, $125k! Yeap, because the other $50k is essentially locked up, you are penalized for touching it. So finally Dr. Mo, how much money did you earn in 2012? (With a sad, limp face)… $125,000.

Well, $125k is still an amazing sum of money but then again, I don’t want to get into the debate of whether doctors are underpaid for fishing stool out of someone’s ass or opening an abscess on the groin of someone with less than ideal hygiene standards.

So, back to that 10%. It’s important we understand the actual numbers behind the 10% instead of just looking at the very ugly 10% value.

 

Breaking Down the 10% Tax Penalty

On the surface it would seem that if you put $50k aside in your retirement account in 1 year (you are allowed up to $54,000 for 2017) then a 10% penalty would equate to $5,000 – but that’s why I am writing this post because that’s not accurate.

You see, the $50k which you contribute to your qualified retirement accounts will go up in value when invested – otherwise, why would you buy index funds with it. If that $50k went up by 4% one year, 5% the next year, 3% the third year, 6% the fourth year and 0% for the next 6 years, then you would end up with an account value of $59,612.

Keep these numbers in mind:

  • IRS 10% early distribution penalty
  • Your $50,000 investment contribution
  • Your investment’s $59,612 maturity value

If you withdrew the entire $59,612 from that retirement account in the 10th year then you would pay around 15% for federal taxes after personal exemption and itemized deductions. You would pay anywhere from 0%-10% for State taxes depending on where you live.

Let’s say that after exemptions/deductions you bring your taxable income down to $40,000 (from the $59,612 account value).

So, 15%+10% (for sake of simplicity) of that would mean you’d owe $10,000 in taxes on that $59,612. This is what you would owe irrespective of whether you are 12 years old or 112 years old. This means that the $10,000 you owe in income taxes isn’t even part of the 10%-penalty discussion.

Now for that 10% penalty. The account balance is $59,612 – so you would owe $5,961. How much of a “loss” is this for you? How penalized do you feel knowing that your account went from $50k to $60k and that you profited 8% even after the penalty?

For the mathematically challenged, your account grew $10k in value over 10 years and your 10% penalty equated to $6k which still left you with $4,000. That’s an 8% rate of return on your investment – pretty sweet, no?

 

Perspective On The 10% Tax Penalty

Some readers already have a firm grasp of how to interpret this 10% tax penalty, others might still see it as a major obstacle. I want to mention a few other things which might help drive the point home, specifically about how to put this 10% into a real world perspective.

10% Lifestyle Inflation

Let’s say you save $50k a year in a retirement account for 10 years, that’s $500k invested. When you go to withdraw the money let’s assume your lifestyle increased by 10%. Maybe you now have a new mouth to feed or picked up a new hobby. It really doesn’t take much to increase our lifestyle costs by 10%.

If you spend $5,000/month and bought a new car, you could easily add $500/month to your budget. That’s equivalent to that 10% tax penalty you would have to pay for accessing your retirement accounts early.

If your annual household budget is $60,000 and you decided to now take a $6k vacation once a year then you increased your household budget by 10%. The point being, wouldn’t you rather have access to your retirement account earlier and perhaps cut out a little in other areas of the budget? Everyone will answer that differently – but I, for one, want that option.

10% Discount By Moving To Another State

If you were living in Oregon or California or New York, you’d be paying around 10% a year towards State income taxes. If you had a taxable income of $200k as a physician, you would owe $20,000 to your State. But you could move strategically to a lower income tax State and gain a 10% discount on taxes.

I live about 7 miles from the Washington border where State income taxes are 0%. California is adjacent to Nevada, another 0% income tax State. If I moved to such a State from a high-income tax State, I would essentially negate that 10% penalty.

Cost Of Holding Down A Job

The person who wants/needs access to their retirement account is someone who either can invest it in something far more lucrative than mutual funds or wants to cut down on work and live off of their investments. When physicians semi-retire or fully retire, a lot of work related expenses decrease as well – far in excess of 10%.

There is commuting, conferences, rushing to get chores done, hiring out a lot of household maintenance due to lack of time, eating out, taking expensive flights to work around vacation time and a whole lot of other job-related expenses.

 

Strategies To Avoid The 10% Tax Penalty

Let’s talk about 3 ways you could forgo the 10% tax penalty. I have discussed these in various posts previously and have linked to them below.

1. The IRA Ladder Method

The IRA ladder method involves slowly converting some of your traditional IRA accounts to a Roth IRA. This is a taxable event but allows you access to the Roth IRA contribution after a 5-year time to maturity, tax-free and penalty-free.

Below is a great infographic by the website NEED2SAVE.

2. SEPP or Rule 72t

Rule 72t is what allows a person to gain access to their retirement funds before reaching age 60. You establish recurring monthly/annual payments which you cannot stop until age 60 and thereby avoid the 10% early distribution tax penalty.

3. IRS Exemptions To The 10% Penalty

The IRS website has an exhaustive list of reasons why you could gain access to your retirement funds before age 60 without paying the penalty. Major medical expenses, first time home buyers and total disability are among those reasons.

 

In Summary

Even with the 10% penalty that the IRS has in place, a well-invested retirement account should profit you more than the 10% can wipe out. What matters is how sound your underlying investment strategy is and when you decided to cash out.

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