401k withdrawal penalty - theoretical question

Assuming your employer contributes 50%, does the math work out in that in general you are net positive even if you cash out your 401k before 591/2, with all taxes and penalties:

$10k contribution

$5k employer match

$15k balance in your 401k, gross cash-out

10% early withdrawal penalty $1,500

net tax liability $5000 x 30% = $1,500

net cash-out, $12k

proceeds net of contribution, $2,000

ignore common sense for the purposes of the example - any big wholes in the assumptions?

Why does the 30% tax rate only apply to $5000 and not $15000?

Good point, since 401ks are funded with pretax dollars.

Incidentally, with a Roth, you get penalties and taxes on the portfolio growth, but everything you’ve actually put in as principal away can be withdrawn without penalty if necessary, because you’ve already paid tax on that money. Obviously it’s not a good idea in terms of compounding potential, but in a bind, it’s an option.

the 30% tax rate applies to the $15k but the $10k pretax contribution has lowered your taxable income. At the end of the day, if you contribute and withdraw in the same tax year your taxable income went up by net $5k - no?

Nope, 15k

Assume you put away 10k of your 100k salary.

With no withdrawals you will pay taxes on 90k

With all withdrawals you will pay taxes on 100k + 5k employer contribution

so net 15k

No. Withdrawels from retirement plans are treated as income and will be added back to your AGI.

Would you get a better return to only contribute $5k and match $5k?


Thanks for the responses. My fault for not being clear enough what I am comparing. I think most people in their answer were comparing A) salary income - contribution vs B) salary income - contribution + wthdrawal. Clearly there is an higher tax liability associated with scenario B, including the early withdrawal penalty.

I am comparing scenario B) above with scenario C) salary income + do nothing.

So, using ZeroBonus’ numbers from above, C) keep $100k of salary and pay tax on it, or A) “circulate” $10k through your 401k: $100k - 10k + 15k = $105k taxable income, plus another $15k * 10% additional tax liability from the penalty.

The point is that circulating money through your 401k gets you a net positive even after factoring the extra tax penalties. The conclusion would obviously be different if the employer match was lower and/or the tax penalty was higher.

Yeah, the impression I am starting to get is: Keeping money in 401k > Putting money in 401k with employer match but withdraw early > Do nothing. Unless there are penalties or vesting for the employer match part. Seems like this would vary by company.

This is interesting. So if you already have alternative plans to fund your retirement, this strategy can potentially allow you to bring home a few extra $s by basically rerouting a portion of your pay through 401k

I wonder if anyone has ever tried this.

I’m not sure I’m understanding the question. But this is what I’m gathering.

You think you can put $1 into a 401k, and an employer will match it with $1. Then, you can immediately withdraw $2, so you’ve magically made $1. (minus taxes and penalties)

This probably won’t work. There’s usually a “vesting period”, where the money doesn’t belong to the employee. The company’s dollar will show up in your statement, but it’s not really “yours” until you’ve been there for five years or something. (Look up ERISA guidelines for details.) As such, you can’t withdraw it or borrow from it.

So, if you put in a dollar and the employer puts in a dollar, then you try to withdraw anything, you’ll only be able to withdraw your dollar. The company will then withdraw theirs.

No free lunch.

If, however, it’s a SEP IRA or a profit-sharing plan, or otherwise immediately fully vested, then you could get the free lunch.

That doesn’t make it any smarter–you’re still losing money due to the penalty. You might get a little more income, but your net worth will ultimately suffer because of the 10% early withdrawal.

If you plan on retiring, then your oppertunity cost is paying the penalty vs not paying the penalty… so don’t pay the freaking penalty.

Has anyone ever taken a loan out of their 401k? Im wondering if I can take the money out pre-tax or if they tax it as income when you take the loan? Basically, if you want to buy a car you can do it pre-tax and using you’re company’s match this way? Also, my 401k you have to pay interest, but only to yourself, which isnt a big deal, the implied interst rate would then be the returns you forego in the market- but if you pay yourself back quickly this isnt a big deal.

Don’t try to game those funds. Taking out money before retirement is there for people who are deciding whether it’s better to be bankrupt now or bankrupt when they are old. If you’re looking at homelessness as an alternative, then do it. Otherwise don’t.

And if you are thinking of declaring legal bankruptcy, some retirement funds are protected, so be careful about making those touchable.

I took some out to get to 20% down on my house. No, it isn’t taxed. Yes, you can take out the company match provided you’re vested. I have to pay myself 4% on the loan.

A couple other things to consider: Some 401k providers charge interest where you pay them. That’s a legal grey issue so if you push back hard enough lots of times they’ll drop it. If you leave your job you may have to pay the full amount. And, in many plans (including mine) you can’t make extra payments towards the principal. If you want to pay it off early you have to pay the full lump sum.

@ Systematic

“If you plan on retiring, then your oppertunity cost is paying the penalty vs not paying the penalty… so don’t pay the freaking penalty.”

I think we’ve already established that, if the question is to withdraw early or not withdraw early, the answer is - don’t withdraw and pay the penalty.

My question was, to contribute and withdraw early or not to contribute at all? To the extent you can generalize, I think we got this answer too as succinctly illustrated by the set of two inequalities written by ohai. As several others have pointed out, the specifics would depend on the vesting and matching rules of your plan as set by your employer.

PS. as far as taking loans - I haven’t, but I think you don’t pay tax on it unless you “default” on your loan. when you default, it essentially becomes an early withdrawal and you are taxed, plus the penalty

I think what is confusing about Mobius’s proposition is that the employer match is your money whether you withdraw early or not. I think of my employer match as part of my pay package, because it is part of my comp, just like health care. You are not “gaming the system” by withdrawing early. You are accepting a 10% penalty and forgoing future compounding. It is functionally no different than if there were no match at all. What if you got a 5% raise that you had to invest in your 401k, but only if you contributed 5% to your 401k first…that is the way to think about the match.

You may be able to eek out some extra comp by withdrawing early compared to not contributing at all, but, as previously stated, there are vesting periods for most employer matchs. Only wat this strategy makes sense is if the match vests immediately and you cannot afford to save any money and need the extra $1 or $2k from withdrawing the match early. I say $1 or $2k because anybody who makes enough money to have the employer match more than that amount should be able to save something, or they need to take a look at their expenses.

The only reason to withdraw or take a loan from your 401k, unless you are in danger of bankruptcy, is if you have an opportunity where the returns net of any penalties or taxes are well above what you can expect in your 401k. For example, if you took a loan out for a lucrative RE deal that you could get a piece of. If you take out a loan from your 401k then there are no penalties, but you forgo any capital appreciation on the amount of the loan, which is why you should be investing any 401k loan in something you think has a good return and/or very low risk.

Yeah, I thought about that exception too, although that 10% plus income taxes plus the next best option that is available within the 401(k) opportunity set is a pretty high hurdle rate.

And also, I did forget that Mobius was looking at this as a way to capture the company match and spend it now, although why one wouldn’t want to leave it in the 401(k) and simply free up other funds for spending/personal investing is beyond me (unless one is looking at bankruptcy and simply needs the money right now).

^ Yeah, but lets stay you’re going to spend $10K on some lap dances- take the loan, pay for it pre-tax and then defer 100% of your comp for the next month topay yourself back.

No penalty, presummable you dont pay income tax because its a loan

You’ve saved yourself (marginal tax rate * loan amount) - (portfolio return*loan amount)

If the market is down over the period the interst rate would even be negative on top of the tax savings.

You have a limited amount of time to pay back the loan, or else it becomes a taxable distribution, subject to the 10% penalty. I think the timeline is three years.

EDIT: The timeline is five years. Also, the maximum that you can borrow is A.) 10,000; or B.) the lesser of $50k or half of the PV of the nonforfeitable accrued benefit.