Small withdrawals from IRA

Question

This is my first posting to this forum.

Throughout the years I put a lot of my pre-tax income into my 401(k) (before I got married). Last year my company was sold so I rolled my 401(k) into a Traditional IRA. I'm not putting money into my IRA but I am putting money into my new company's retirement because they had such a good deal. They match up to 6% and give us 3% at the end of the year so you can't beat that. The other company I worked 25 years for didn't match any contributions and gave me a $65K pension.

I decided to take my pension as a lump sum (so to speak) so I rolled $15K and $10K from my pension to my IRA and will $10K a year for the next four years. That's just the way they had to set up.

I'm 46 and my IRA is already worth $464K. My financial adviser said I was on track. When will I retire? No later than 59.5, sooner if I can. My house is paid off so I am not really in any major debt.

Here is my question. A few years later I got into a financial bind. Long story. I had to take out a $35K loan against my 401(k). I tried paying it back $630 a month at a time and got the loan down to $27K until I rolled my 401(k) over to an IRA and decided to just default on the loan. Trying to pay that much money back and the loan itself had been a dark cloud over my head for three years.

The other issue is my wife gets $12K in disability per year. So this has put me above the $76K threshold into the 25% tax bracket. Not only that but 85% of her disability is taxable. I'm allowed to make up to $153K (which I will never earn) before I end up in the 28% tax bracket so I've pretty much accepted I'm in the 25% tax bracket.

This is the first year I've never gotten any money back and have ever had to pay money to the IRS which is around $1300. So instead of getting back around $5500, I'm $1300 in the hole.

So where is this going?

Is taking small sums from your IRA really that detrimental? I mean as far as tax is concerned?

I know the stock market can take a dump and I can lose money but I'm averaging a gain of around 6% or $6,000 a month (sometimes $1800 a day when the stock market is up) which almost twice my take home pay.

Someone please correct me if I am wrong about this but I did some rough math one day.

My company is going to be sold once again! I'm not sure what kind of retirement the new owners are going to have but if they are not going to match any contributions, I'm rolling what I little I have in my current 401(k) over to my IRA and would like to contribute to my IRA.

I can put $5500 in my IRA before taxes, SS and medicare tax. Isn't the 10% "penalty" really to cover SS and the medicare tax that you did not pay before putting money into your retirement?

If I managed to save (or not spend) $5500 and contributed that to my IRA before taxes (including SS and medicare tax) that money would gain 6% interest. Well assuming the stock market does well.

But if I put that money in my bank's money market account, I'd be paying income tax, SS and medicare tax then earning .03% interest (sorry isn't it).

Would it not be better to contribute that $5500 to my IRA and if I didn't need it, great, let it grow but if I did need it toward the end of the year, do an early withdrawal?

I don't think you can pay taxes up front when making an early withdrawal from an IRA can you? Reason being, how would the government know how much to tax you on at the end of the year based on your total earned income?

So if I needed to withdrawal $5500 and I am in the 25% tax bracket, I would owe the government $1925 in taxes+ 10% penalty. So if I withdrew $7425 to cover the tax and penalty, I would then be taxed $2600 (an additional $675). Sounds like a cat chasing it's tail trying to cover the tax.

I'm sure these figures are not 100% correct. Am I totally off track?

I've heard people say taking any money out of an IRA, you'll get hit paying 40% tax on the money. But based on this year's W-2 form, I had an accountant do my taxes and the $27K loan was added as earned income then in another block there was the $2700 amount for the penalty.

I guess what I am trying to ask is, how can I make a withdrawal from an IRA without having to pay tax on tax. Does any of that make sense?

Like I said if I have $464K in my IRA, my house is paid off and I'm at least 13 years from retirement, is taking $5000 a year really going to hurt me?

Answer 1

Yes, it really will hurt you to keep pulling your money from your IRA. Your best bet is to set up a payment plan with the IRS, and pay the taxes you owe now, as well as adjust your withholding (with a new W-4 to your payroll department) so that you don't have a large tax liability next year.

These tax advantaged plans really are designed to penalize you if you pull the money out early to give you incentive to keep the money for retirement. Your best bet is to make a monthly budget that includes your tax payments for taxes owed this year, as well as higher deductions from your paycheck to properly withhold taxes for next year.

Answer 2

First - Welcome to Money.SE. You gave a lot of detail, and it's tough to parse out the single question. Actually, you have multiple issues.

$1300 is what you need to pay the tax? In the 25% bracket plus 10% penalty, you have a 65% net amount. $1300/.65 = Exactly $2000. You withdraw $2000, have them (the IRA holder) withhold $700 in federal tax, and you're done.

All that said, don't do it. Nathan's answer - payment plan with IRS - is the way to go.

You've shared with us a important issue. Your budget is running too tight. We have a post here, "the correct order of investing" which provides a great guideline that applies to most visitors. You are missing the part that requires a decent sized emergency fund. In your case, calling it that, may be a misnomer, as the tax bill isn't an unexpected emergency, but something that should have been foreseeable.

We have had a number of posts here that advocate the paid in full house. And I always respond that the emergency fund comes first. With $70K of income, you should have $35K or so of liquidity, money readily available. Tax due in April shouldn't be causing you this grief. Please read that post I linked and others here to help you with the budgeting issue.

Last - You are in an enviable position, A half million dollars, no mortgage, mid 40s. Easily doing better than most. So, please forgive the soapbox tone of the above, it was just my "see, that's what I'm talking about" moment from my tenure here.

Answer 3

You have several questions in your post so I'll deal with them individually:

Is taking small sums from your IRA really that detrimental? I mean as far as tax is concerned?

Percentage wise, you pay the tax on the amount plus a 10% penalty, plus the opportunity cost of the gains that the money would have gotten. At 6% growth annually, in 5 years that's more than a 34% loss. There are much cheaper ways to get funds than tapping your IRA.

Isn't the 10% "penalty" really to cover SS and the medicare tax that you did not pay before putting money into your retirement?

No - you still pay SS and medicare on your gross income - 401(k) contributions just reduce how much you pay in income tax. The 10% penalty is to dissuade you from using retirement money before you retire.

If I ... contributed that to my IRA before taxes (including SS and medicare tax) that money would gain 6% interest.

Again, you would still pay SS and Medicare, and like you say there's no guarantee that you'll earn 6% on your money.

I don't think you can pay taxes up front when making an early withdrawal from an IRA can you?

This one you got right. When you file your taxes, your IRA contributions for the year are totaled up and are deducted from your gross income for tax purposes. There's no tax effect when you make the contribution.

Would it not be better to contribute that $5500 to my IRA and if I didn't need it, great, let it grow but if I did need it toward the end of the year, do an early withdrawal?

So what do you plan your tax withholdings against? Do you plan on keeping it there (reducing your withholdings) and pay a big tax bill (plus possibly penalties) if you "need it"? Or do you plan to take it out and have a big refund when you file your taxes? You might be better off saving that up in a savings account during the year, and if at the end of the year you didn't use it, then make an IRA contribution, which will lower the taxes you pay. Don't use your IRA as a "hopeful" savings account.

So if I needed to withdrawal $5500 and I am in the 25% tax bracket, I would owe the government $1925 in taxes+ 10% penalty. So if I withdrew $7425 to cover the tax and penalty, I would then be taxed $2600 (an additional $675). Sounds like a cat chasing it's tail trying to cover the tax.

Yes if you take a withdrawal to pay the taxes. If you pay the tax with non-retirement money then the cycle stops.

how can I make a withdrawal from an IRA without having to pay tax on tax.

Pay cash for the tax and penalty rather then taking another withdrawal to pay the tax. If you can't afford the tax and penalty in cash, then don't withdraw at all.

based on this year's W-2 form, I had an accountant do my taxes and the $27K loan was added as earned income then in another block there was the $2700 amount for the penalty.

So you paid 25% in income tax for the earned income and an additional 10% penalty. So in your case it was a 35% overall "tax" instead of the 40% rule of thumb (since many people are in 28% and 35% tax brackets)

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The bottom line is it sounds like you are completely unorganized and have absolutely no margin to cover any unexpected expenses. I would stop contributing to retirement today until you can get control of your spending, get on a budget, and stop trying to use your IRA as a piggy bank. If you don't plan on using the money for retirement then don't put it in an IRA. Stop borrowing from it and getting into further binds that force you to make bad financial decisions.

You don't go into detail about any other aspects (mortgage? car loans? consumer debt?) to even begin to know where the real problem is. So you need to write everything down that you own and you owe, write out your monthly expenses and income, and figure out what you can cut if needed in order to build up some cash savings.

Until then, you're driving across country in a car with no tires, worrying about which highway will give you the best gas mileage.