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I'm fatally ill and that diagnosis is final and there's no doubt I am going to die long before retirement age. I'm married and we have two young children.

I have about one year's worth of salary saved up after contributing the maximum to my 401k for the last decade and a half of my life. Not a lot, about $60,000. I'm frugal, we live modest, but that money isn't doing anything for us right now. I figure if I withdraw all of it, that the government will take 50% worst case scenario. Best case, about 40%. Someone with more knowledge can drop the very specific amounts. Anyhow, the government isn't going to look at me and have pity for my condition or strategic planning. They will get their cut. So, should I take the loss and use the difference ~ $30,000 to get our mortgage down, so when I'm gone my spouse will have a lower payment or should I leave the money there so she and my children will have a lump sum (but still have to pay the taxes)?

As advice comes in, other thoughts come to mind, which may be important:

  • I'm going to go through a period where I can no longer work before I pass away. During that time our household income will be about half of what it is now.
  • Are there risks of leaving the money in or taking it out. For example, it is very probable that I'll be hospitalized for a while. Medications and doctor bills will probably accrue. Worst case scenario, bill collection companies will come knocking. So, is the money safer in retirement accounts or invested in our house? Would it be better to make my children the beneficiaries?
  • If we refinance now, we can lock down a rate of 3.75% and using approximately 30,000 of the money while holding back the other half to pay the taxes and penalties will reduce our mortgage by an estimated $200 per month.
  • The various statements you have made in response to the answers posted by @JoeTaxpayer and myself lead me to believe that there are many things about your financial situation that you are either not comprehending (e.g. your current or future tax bracket) or are not comfortable divulging. In either case, the scenarios that are being painted are so different that it is difficult to answer questions or to give any reasonable advice. I urge you to get financial advice from someone that you are more comfortable talking to rather than from a public forum. – Dilip Sarwate May 24 '12 at 17:45
  • No, I find your responses very helpful though I have to dig for details like specific tax brackets. With that I reviewed the tables and found that we are in the 25% bracket and will indeed drop to the 15%. So, I believe this means that when I become unable to work I can take withdrawals at 15% over a couple years to avoid raising our "income" above 70,700. That doesn't include the 10% penalty; however, if the Secretary accepts the doctor's diagnosis, that 10% penalty will be waved. So, before taking withdrawals my condition must worsen. – Citizen Dos May 24 '12 at 18:11
  • Once transferred to the IRA, there's no secretary deciding. You specify 'disabled' on the withdrawal and only are questioned if audited. A doctor's statement should suffice, we're not talking huge sums. – JTP - Apologise to Monica May 24 '12 at 18:15
  • Thanks for the tip Joe. Of the many factors and dilemmas we face is the fact that I will be unemployable in my employers eyes long before I'm disabled according to government standards. We've looked into this. My employer will only tolerate my decline to a certain point, while by government standards (code) I'll be bedridden before I qualify as disabled. Point being, that if you are correct, your tip is very good advice. – Citizen Dos May 24 '12 at 18:21
  • Also bear in mind that with most mortgages, paying down the mortgage in part does not relieve you of the onus of making the same monthly payment month after month until the mortgage is fully paid off. Of course, it might be possible to negotiate this with the lender and have the paydown count as early payment of N monthly payments, but this is by ne means guaranteed unless it is already part of the contract. What usually happens with a partial prepayment is that the duration of the mortgage is shortened, the monthly payment obligation is still the same, but for a shorter period. – Dilip Sarwate May 24 '12 at 19:23
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I'm sorry for your situation.

If 15 years of maximum savings only has you at $60K, I'm going to assume you are currently in the 15% bracket. A withdrawal will cost you 15% (and maybe push you into the 25% bracket) as well as the 10% penalty, and state tax. Don't do it.

Be sure your 401(k) has listed beneficiaries. Your wife will be able to take an annual withdrawal, and pay very little, probably 10%, maybe 15% worst case. You reference that she'd have a lump sum. Yes, but she won't have to take it all at once. She should be able to transfer the funds from the 401(k) to an IRA, and withdraw small amounts each year.

It's a very rare circumstance where an early 401(k) withdrawal actually makes any real economic sense.

  • My income combined with my spouse's puts us into the highest bracket. Years ago, I had the same balance. I lost a lot during the recession and despite what the economist say, it never recovered. The only recovery I've recognized is that my balance has gone up because I continued contributing. Point is, I anticipate paying the maximum. So, to be clear, would you say that worst case scenario, I'll have to pay 50% of my savings to the government if I take it out now? What are other risks of leaving it in? (Another huge loss? Increase in government taxes?) – Citizen Dos May 24 '12 at 16:43
  • Do you have any idea what income your wife will have after you pass? And after she retires? This is the question, really. The benefit of the pretax retirement accounts is to save now at your marginal rate 28/33%, and then when you withdraw, it starts back at 0/10/15. I wrote a decent explanation how marginal rates work. rothmania.net/marginal-rates The investments within the account are another story, there should be conservative choices as well as more aggressive. – JTP - Apologise to Monica May 24 '12 at 16:51
  • I assume and hope her income will be the same and perhaps increase with cost of living over her years till she retires. Part of my dilemma is that very soon, I won't have the energy to work anymore myself. When that comes, she'll be carrying me and the children. I'm looking for ways to reduce our cost of living and the mortgage is one way to do it. Every dollar counts and those dollars out there right now are doing nothing for us and seemingly (based on experience) have a chance of dimensioning at the very least depreciating. – Citizen Dos May 24 '12 at 16:56
  • I trust that when you are unable to work, you will drop a bracket, or two. You then transfer 401(k) to IRA, and via Sec 72(t) joetaxpayer.com/section-72t-withdrawals you can make withdrawals, pay tax but no penalty. – JTP - Apologise to Monica May 24 '12 at 17:23
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As JoeTaxpayer says, "It's a very rare circumstance where an early 401(k) withdrawal actually makes any real economic sense."

Your statements that one year's salary for you is $60K and the combination of your spouse's income and yours puts you into the highest income tax bracket together lead to the conclusion that your spouse's income is considerably higher than yours. If this income will continue past your death (e.g. you two are not in a joint venture that will collapse when you pass away because she cannot do the work by herself), then it is very definitely to your joint advantage to leave your money in a tax-deferred account for as long as possible. Her income should be enough to cover the mortgage payments. Also, rather than take the money out and paying taxes at a high rate right now, your spouse can roll over the 401k money into an IRA and withdraw only small amounts per year, paying taxes spread over the years rather than in a lump sum.

  • I'm making an ignorant statement in saying "highest income bracket". I'm making that assumption based on progressive scales I vaguely recall seeing when filing our taxes. The government gets a much higher percentage of my income or her depending on perspective when combined. She earns about what I do, sometimes slightly more. – Citizen Dos May 24 '12 at 17:09
  • Another factor, we're going to go through a period where I'm unable to work before I pass. So, our income will drop by about half. Dropping to half might change the rate that withdrawal is taxed? – Citizen Dos May 24 '12 at 17:13
  • Rollover into a Traditional IRA? This will insulate her from market risks? Is there any penalty or tax for doing this? – Citizen Dos May 24 '12 at 17:30
  • There is no penalty or tax when a 401k plan is rolled over into a Traditional IRA unless you make a real mess of things (e.g. take the money in cash from the 401k into your personal account and then fail to send it on within 60 days to the custodian of the IRA account). Stick to a trustee-to-trustee transfer of funds if you do a 401k to IRA rollover. Market risk will be there regardless of whether the money is in a 401k or an IRA, but 401k choices are restricted, IRA choices are more plentiful. If you are really concerned, put the money into CDs where risk is minimal but gains are small too – Dilip Sarwate May 24 '12 at 17:38
  • @CitizenDos - I offered links in the comments under my answer. Not trolling for traffic, but to directly help you understand your situation (regarding marinal rates, and ability to withdraw once not able to work). – JTP - Apologise to Monica May 24 '12 at 18:05
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It seems that you're asking for a legal/tax advice, and I vote to close the question as off-topic for that. This is not the place.

But on the second thought, I will share some of the ideas I have, provided of course that you will not consider them as any sort of tax advice whatsoever, and will not rely on it for any tax planning without verifying with a licensed professional.

Taking 401k money out just like that means that you are going to pay your taxes on that money plus additional 10% penalty. As @JoeTaxpayer said, this rarely makes economic sense.

However, taking 401K money out to pay your medical bills (which would otherwise be deductible, pay attention to the nuances) doesn't trigger the penalty. It looks like in your case you might (unfortunately) have a chance to use this provision.

Another case when you can withdraw money without penalty is disability, which according to what you describe is, unfortunately, a situation you're very likely to find yourself in.

Also, you can withdraw funds as income for a substantial period of time, and under certain conditions it will not be subject to the 10% penalty.

Of course, leaving it to the beneficiaries, as mentioned by others, is another and very valid option.

See publication 575 for specific details, and be sure to consult a tax professional before doing anything.

  • +1 good clarification, my comments were not clear, disability permits penalty free withdrawal, and sec 72t does as well. These are separate rules. If you are not legally disabled, use sec72t. – JTP - Apologise to Monica May 25 '12 at 1:56
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Something I wanted to posit: Do you have a life insurance policy, either taken out yourself or offered through your company? Many of these policies will pay out prior to the death of the covered individual, given statements by medical professionals that the person has a terminal illness or condition. The benefit, once disbursed, can be used for almost anything, including to pay down a mortgage, cover medical bills and other care expenses, etc.

If you have such a policy, I urge you to look into it; that is the money that should be used for your end-of-life care and to ease the burden on your family, not your retirement savings. Your savings, if possible, should be left to continue to compound to provide your wife with a nest egg to retire with.

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