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So I had to pull funds from my IRA account earlier this year. I had taxes withheld and realize there is a penalty, however, my question is two part: with penalties and taxes for early withdrawal, I am looking at approximately 35% on gross proceeds, correct? (say this is $1k withdrawal) Broken down - a $100 penalty (10%) and $250 income tax (25% bracket). Am I correct? If I am ok paying that, it is my decision, right?

Secondly, if this $1,000 was in a regular broker account and made $1,000, I would be taxed a short term capital gain of $250 (or 25% * $1k gain) netting $750 profit. If distributions frequently or for more $$$ say $10k withdrawals (part of a ~$50k capital gain), the IRS would ask for an estimated quarterly tax plan of ~$7k or ~$8k, however, in the IRA, they could not because the gains are tax deferred and therefore they cannot project/reach in/ask for such a plan. Am I correct? Pulling the funds out of the IRA vs. a cash account seems fairly harmless then.

I can't believe it is that simple, but it appears I have found a bypass to QET. My 10% 'penalty' is actually paying the government to preserve my cashflow another ~$28-35k. What am I missing?

Update: I did some research and a subsequent spreadsheet. Assuming short term gains only in the IRA, comparing a payroll tax to the penalty and cap gains 'tax' from early distribution, there is a benefit around $80k of income (withdrawal) [better than a payroll tax in net income terms]. The added benefit is in cases of excessive gains, if withdrawals are kept even ~$5k, remaining gains are not taxed in the account and grow deferred. This is especially important in calculating 'cashflow' and tradeable funds (rather than the government 'claiming' said funds as taxable in the year earned. But managing cashflow is key as 'tax' funds remain in account and need to be ear marked.

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    Why is your short term cap gain tax higher than your marginal rate? They should be equal. – JTP - Apologise to Monica Aug 7 '14 at 1:09
  • Even aside from the short-term/long-term issue, I think there's something I'm missing here. Even assuming 35% is correct, in both examples you give, the rate is 35% (plain 35% in one case, 25%+10% in the other case). Where does the notion of "$100 ahead" come from? – BrenBarn Aug 7 '14 at 1:10
  • 'Ahead' as in $750 net vs. $650 net proceeds. Correct?Given short term tax rate fluctuations, it appears beneficial for one to draw from an IRA and take the penalty and cap gains taxes per transaction. Benefit #1: tax rate could be net lower in some cases and Benefit #2: circumventing potential quarterly taxes by leaving bulk of capital gains in IRA while drawing down as necessary, paying tax every transaction and deferring 'penalty' for April the following year. Comparably, no social security or medicare deductions as there are in payroll further boosting 'net tax effect'. – david Aug 7 '14 at 2:22
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    What do quarterly estimate have to do with anything? – littleadv Aug 7 '14 at 7:38
  • If you had a large gain that wasn't covered by your employment withholding, or by the investment company withholding funds, you would only have to pay an underpayment penalty if you didn't meet specific safe harbor limits. But your safe harbor limits for next year would be so high that you might be forced into quarterly payments next year to prevent the problem from happening again. – mhoran_psprep Aug 7 '14 at 11:29
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Bottom line is this: there's no "short term capital gains tax" in the US. There's only long term capital gains tax, which is lower than the regular (aka ordinary) tax rates. Short term capital gains are taxed using the ordinary tax rates, depending on your bracket.

So if you're in the 25% bracket - your short term gains are taxed at 25%.

You're describing two options:

  1. Withdrawal of $1K from IRA.
  2. Realizing $1K short term gain on your investments in a taxable account.

For the case #1 you'll pay 25% tax (your marginal rate) + 10% penalty (flat rate), total 35%. For the case #2 you'll pay 25% tax (your marginal rate) + 0% penalty. Total 25%. Thus, by withdrawing from IRA you'll be 10% worse than by realizing capital gains.

In addition, if you need $10K - taking it from IRA will make the whole amount taxable. While realizing capital gains from a taxable account will make only the gains taxable, the original investment amount is yours and had been taxed before. So not only there's a 10% difference in the tax rate, there's also a significant difference in the amount being taxed. Thus, withdrawing from IRA is generally not a good idea, and you will never be better off with withdrawing from IRA than with cashing out taxable investments (from tax perspective).

That's by design.

  • Though if the withdrawal is from a Roth IRA then things could be a bit different as contributions could be withdrawn without penalty or taxes in some cases. – JB King Aug 7 '14 at 19:49
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    @JBKing Roth is a whole different can of worms. – littleadv Aug 7 '14 at 21:06
  • Nitpick: it is possible though not common to have nondeductible (post-tax) contributions in a trad IRA, called basis, and in that case a pro-rata portion of the distribution is untaxed; see pub 590B and form 8606. @JBKing: for Roth contributions are always taxfree, and earnings also if more than 5 years after opening AND after age 59.5 OR certain special cases (first time homebuyer, qualified education, excess medical, reservist called to duty, natural disaster). – dave_thompson_085 May 25 '18 at 18:17
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There is not a special rate for short-term capital gains. Only long-term gains have a special rate. Short-term gains are taxed at your ordinary-income rate (see here). Hence if you're in the 25% bracket, your short-term gain would be taxed at 25%. The IRA withdrawal, as you already mentioned, would be taxed at 25%, plus a 10% penalty, for 35% total. Thus the bite on the IRA withdrawal is larger than that on a non-IRA withdrawal.

As for the estimated tax issue, I don't think there will be a significant difference there. The reason is that (traditional) IRA withdrawals count as ordinary taxable income (see here). This means that, when you withdraw the funds from your IRA, you will increase your income. If that increase pushes you too far beyond what your withholding is accounting for, then you owe estimated tax. In other words, whether you get the money by selling stocks in a taxable account or by withdrawing them from an IRA, you still increase your taxable income, and thus potentially expose yourself to the estimated tax obligation.

(In fact, there may be a difference. As you note, you will pay tax at the capital gains rate on gains from selling in a taxable account. But if you sell the stocks inside the IRA and withdraw, that is ordinary income. However, since ordinary income is taxed at a higher rate than long-term capital gains, you will potentially pay more tax on the IRA withdrawal, since it will be taxed at the higher rate, if your gains are long-term rather than short term. This is doubly true if you withdraw early, incurring the extra 10% penalty. See this question for some more discussion of this issue.)

In addition, I think you may be somewhat misunderstanding the nature of estimated tax. The IRS will not "ask" you for a quarterly estimated tax when you sell stock. The IRS does not monitor your activity and send you a bill each quarter. They may indeed check whether your reported income jibes with info they received from your bank, etc., but they'll still do that regardless of whether you got that income by selling in a taxable account or withdrawing money from an IRA, because both of those increase your taxable income.

Quarterly estimated tax is not an extra tax; it is just you paying your normal income tax over the course of the year instead of all at once. If your withholdings will not cover enough of your tax liability, you must figure that out yourself and pay the estimated tax (see here); if you don't do so, you may be assessed a penalty. It doesn't matter how you got the money; if your taxable income is too high relative to your withheld tax, then you have to pay the estimated tax. Typically tax will be withheld from your IRA distribution, but if it's not withheld, you'll still owe it as estimated tax.

  • BrenBarn, appreciate your insight. I think you confirmed there is not much of a 'penalty' in taking an IRA early other than 10% more tax thru the penalty given a 25% tax bracket as the withdraw is treated as income. The benefit appears in circumventing quarterly taxes if large capital gains are made inside the account vs. a cash brokerage account. You eliminate the 10% penalty in a cash account but if a gain is substantial, the IRS will ask for a quarterly estimated tax. Thus the government destroys your cashflow; in the IRA the gains are a 'deferred' tax 'when taken out'. Is this a loophole? – david Aug 7 '14 at 3:50
  • @david: I hadn't thought of the estimated tax angle. However, with only a $1000 withdrawal, it's unlikely the tax would be enough to result in an estimated tax shortfall. Your question is still not totally clear to me, so perhaps you could edit it to clarify. (For instance, you don't mention anything about estimated tax in the question right now.) – BrenBarn Aug 7 '14 at 4:04
  • Let's say we are talking $50k or $100k capital gain in a quarter. I would assume this would prompt a red flag to the IRS given my broker would be obligated to report such quarterly. I withdraw $10k or $20k in either case. In the IRA, the IRS could not reach in and 'claim'/suggest or ask me to start a ~$5k quarterly tax plan as the capital gains grow tax deferred, correct? In the cash account, the IRS could 'enforce' such a plan. I think this would be their logic. Is my logic sound? – david Aug 7 '14 at 4:10
  • @david: That is an interesting question, and you may be right. Again, though, I suggest you edit your question if that's what you asking, because that seems totally different from what you said in your question. – BrenBarn Aug 7 '14 at 4:18
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    @PeterK.: Well, it's all a matter of baseline. If I were to say there is a special rate for short-term capital gains, it could imply that short-term capital gains are taxed differently from ordinary income, which they're not. So by "special" I mean "different from ordinary income", not "different from other capital gains". I added another sentence to hopefully clarify even more. – BrenBarn Aug 11 '14 at 18:35

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