We have been reading lots of literature about withdrawing funds from tax advantaged accounts like 529 Savings Plans, 401(k)s and IRAs and these articles casually mention the taxes imposed when those accounts are tapped prematurely or for a non-authorized purpose. Two recent reporting events accentuate how important it is for taxpayers to understand these transactions. The first is that credit card debt is back to record levels and the average interest rate on those debts is 20%. This means that unless somehow reduced consumer debt doubles every 3.5 years; a debt growth rate that is disastrous to any financial plan. The second is a statement by BlackRock’s CEO that 40% of people changing employment choose to liquidate their retirement plans with their former employers when offered the chance to do so.

There are times when it makes sense to withdraw money from tax advantaged plans. But it seems that most people doing so don’t really assess the consequence in an effective way. Here we will try to help evaluate the real cost of doing so.

Most taxpayer’s don’t really understand the idea of marginal tax rates. So, let’s start here. Assume you work a minimum wage job. You earn $15,000 a year. The standard deduction for such an individual is $13,850. That means his/her taxable income is $1,150. That income is taxed at 10%. In fact, if you increased your earnings by an additional $10,000 to $25,000 your total federal tax bill would still be 10%. $25,000 in income yields an actual tax due Uncle Sam of $1,150. Thus, your real tax rate is 4.6%. (1,150/25,000).

Until you get to taxable income of $44,725 your tax rate is on 12%. If you earn up to $58,578 your tax rate is no higher than 12% and the first $13,850 is exempt from any tax.

After the $58,578 there is a significant “bump” in your tax rate to 22% but it’s only on the money earned above the $58,578 threshold. At the risk of tedium, your first $13,850 is not taxed. The next $11,000 is taxed at 10% and the amount up to the $58,578 is taxed at no more than 12%. Then income up to 109,225 will be taxed at 22%. After that we get to $194,950 before income is taxed at 24%. If you had income of $200,000 as a single person in 2023 your total federal income tax would be about $37,500 or 18.75%. We sit with many clients who believe the feds are taking 30-35% of their earnings. Those rates do apply but only to that income earned beyond $231,500. Effectively, the government has a 0% bucket (your standard or itemized deductions) a 10% bucket, then 12%, 22% 24%,32%,35% and for income over $578,126, 37%.

Why does this matter? Because if you are going to tap a tax advantaged accounts the actual tax you will pay for your “tap” is governed by your marginal rate. Recall as well that premature withdrawals (before you are 59 years and 6 months old) get hit for a 10% penalty in addition to the tax.

How does it work. Let’s assume that you have $30,000 worth of credit card debt. Your cost to carry that debt at 20% per annum is $500 a month before you even reduce the principal by $1 measly dollar. Your employer announces you are being downsized, losing your $100,000 a year job. The employer “generously” gives you a month’s wages as a termination package but it is going to take you a while to find employment at your current $8,333 monthly wage. Your best estimate is that it will take you 90 days to find employment. You will get some unemployment but the at best that will be $450 a week. You are in a squeeze. Should you be reaching for IRA or 401(k) money knowing it will be taxed? Let’s look ahead.

But first a word of caution. If you have a 401(k) loan, realize that your termination is a “call” on that loan. If you don’t repay it, you will be deemed to have taken a distribution which is taxable equal to the loan balance.

Now you are terminated May 31 but will be paid to June 30. Your best guess is you won’t find new employment until October 1 (90 days). So that’s a $25,000 hole in your income ($8,333×3) for 2024. It will perhaps be filled with unemployment of 13 weeks at $450. That sums to $5,850 leaving a revised “hole” of $19,150.

This may be a provident time to take a retirement distribution. You may need it just to make ends meet. You might better use the moment to retire that nasty credit card debt. To pay off $30,000 you will need a distribution of at least $36,000 because the retirement funds hold back 20% and use it to pay some tax to the IRS on your behalf (much like withholding).

The reason to do so is because you have that $19,150 hole in your 2024 income even if you are back at work on October 1 at the old $100,000 wage. Your retirement distribution is simply filling the hole.

Let’s look at what is the real cost of the $36,000 distribution on your tax bill. You do that by figuring out what your tax bill will look like in the year you make the distribution.

Wages 1/1/24-6/30/24 (including severance)             $50,000

Unemployment                                                               5,850

Distribution from 401K                                                 36,000

Income as of 9/30/24 including 401K payout                91,850

If you don’t land a job until 2025 your unemployment will be an additional 13 weeks or $5,850 and your 2024 earnings will be a few dollars less than you projected when 2024 began. But the anchor of consumer debt is gone if you paid it off. Your tax bill on $97,700 as a single individual will be

                        97,700 less 13,850 standard deduction = 83,850

                        Your tax on that is                                                 13,735

                        Your penalty for early withdrawal of 36,000        3,600

                        Total federal tax                                                   17,135      (17.5% incl penalty)

Now let’s be optimistic and put you back in a job by October 1 at $8,333 a month for 3 months. That’s another $25,000 that will go on the return less the $5,850 in unemployment you didn’t collect because of the new job. Again, $19,150 in fresh income. Most of that will be taxed at 22% but a small portion will be subject to 24% because after $95,000 in taxable income the rate goes up.

The time to hit a tax advantaged account is when there is a hole in your income stream as we had in our example. The other strategy often forgotten is one of timing. If you need to take money, it may make sense to pay off half the debt in 2024 and the other half in 2025, thereby spreading the distribution income and penalty over two tax years instead of taking it in one.

While we tried to keep it simple, the smart move is to review any distribution with an accountant or tax adviser who can run the numbers we have refined to be your income for your relevant tax years. But one thing not to do is dig into a retirement account because it seems too difficult to do a rollover. In fact, most retirement plans will let you keep your account with your former employer until you are ready to move it to the new employer or an IRA. Do not invade retirement unless you absolutely have to because you will drown financially otherwise or because you see a credit card balance that grows like topsy because the rate of interest is insane.

Understanding when and how to time withdrawals from any accounts is kind of a critical skill to retire successfully. Sometimes delaying or staggering a distribution over two tax years (half in December of one year and half a few days later in the next tax year) can make a big difference where your marginal tax rate is about to jump from 12% to 22% or from 24% to 32%.

We watched a recent podcast by Eric Amzalag with something called Peak Financial Planning. We don’t know anything about Amzalag or Peak but in a 20 minute podcast he walks you through the decision trees you encounter when deciding when and how to harvest your retirement savings and social security. He talks fast but Mr. Amzalag illustrates the field of vision for retirement (typically age 62 to age 95) and how you need to consider things like when to take social security and when you will payoff certain things like mortgage or student debt. We have often encountered clients who lament their failure to grasp these concepts and confess they took too much out of savings in the first years of retirement or failed to grasp that when you sell stock in a down market to meet needs, you lose any chance of seeing those securities recover their value when the market turns back up.

The podcast is here; https://www.youtube.com/watch?v=gJHSiKTTT_8

We cover this because divorce planning is financial planning.