This post 5 Steps To Retiring Rich (Step 2) appeared first on Daily Reckoning.
Dear Rich Lifer,
About a year ago, my wife and I were invited to a neighborhood barbecue.
The various meats, prepared by the Argentinean husband, were ridiculously good. The wine, locally-grown grenache, was flowing freely. And then the conversation turned to my status as a well-known financial guru …
“Okay, let me see what you think of what WE just did,” says the hostess proudly.
The short version is that they cashed out the husband’s 401(k) to buy the house we were currently sitting at.
Wine. Lips. Gulp.
About ten adults are all looking at me for a learned response, presumably a supportive one.
Before I can say anything, the wife follows up with all the rationalizations. The house will keep going up. They will always need a place to live. So on and so forth.
It’s not COMPLETELY faulty logic, and I emphasize those threads of truth in my eventual response.
But inside, my mind is doing the actual math …
The house is worth about a million.
So let’s say they cashed out $200,000 for the downpayment.
Federal taxes probably took up at least 20% of that amount. Possibly much more since the lump sum would probably shift them into a higher overall bracket. Still, let’s be conservative and call it $40,000.
Then there’s also that 10% early withdrawal penalty. Kiss another $20,000 goodbye.
And since we’re in California where a six-figure income will easily push you beyond 10% in state income taxes (our top marginal rate is actually 13.3%), they’ll end up paying at least another $20,000 or so to Sacramento.
That $200,000 withdrawal just shriveled to $120,000. Again, under pretty conservative assumptions.
I’ve had a good amount of wine and this is back-of-the-envelope math but this house is going to need to appreciate an awful lot just to make up the money handed over to various government agencies.
“So, sure,” I conclude. “You could have definitely done worse things than that.” I simply refrain from naming what those things are.
In short, I consider early 401(k) withdrawals to be a terrible idea. It is the first, and worst, option you have when it comes time to leave an employer.
Even if you’re at least 59 and a half and actually retiring — or even taking advantage of the “Rule of 55” I mentioned in our primer on these plans — a large lump sum withdrawal isn’t the best idea.
Sure, you can simply withdraw the money penalty free and use it as you see fit.
But your employer will keep 20% of the proceeds for taxes.
What’s more, taking out a large amount of money in one lump sum could still end up bumping you into a higher overall bracket.
So you might still want to consider spreading out your withdrawals over a longer schedule to help minimize the tax implications.
You can even keep all the money invested until required minimum distributions begin at 70 and a half.
Which brings me to other choices that everyone has when it comes to handling …read more
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