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Last Monday’s Reader Case sparked some discussion over whether it makes sense to take the 10% early withdrawal penalty that comes from making a 401(k)/Traditional IRA withdrawal before the age of 59.5 instead of doing the Roth Conversion Ladder.
Well, the counter argument referred to this very thorough and informative post from the MadFientist, who did a comparison of 5 ways of accessing your retirement funds.
In that post, he claimed that in certain situations, deliberately taking the 10% Early Withdrawal Penalty actually beats the Roth Conversion Ladder strategy, which seems completely bonkers and counter-intuitive to me.
So I was at a bit of a dilemma. MadFientist is a fellow Chautauqua speaker, deeply respected in the FI community, and a good friend of mine. Should I just blindly trust my friend, or should I go where the math takes me at the risk of disagreeing with him?
In the end, I decided, as I always do, to MATH SHIT UP and damn the consequences. MadFientist and I can always make up later over his favourite craft beer.
Ready? Here we go!
Now, the biggest, most important conclusion from MadFientist’s post is that putting money into your tax deferred accounts always makes sense regardless of how you later withdraw it. I whole-heartedly agree with that. And, as an added plus, if there’s any employer-based matching program for your 401(k) contributions, it becomes even more of a no-brainer. Free money AND it’s taxed deferred? Yes please!
So that’s all fine and good, but he also claims that in specific cases, withdrawing early and taking the 10% penalty actually beats using the Roth Conversion Ladder. Really? What is this sorcery?
IT’S ALL DOWN TO SIDE HUSTLE
First of all, for the typical early retiree that leaves their job and never works again: No. Unquestionably no.
The draw-down strategy outlined by many FI bloggers including ourselves and in our book, is operating under the assumption that after you retire, you never earn a cent again. In that scenario, an early retiree can convert their 401(k)/Traditional IRA into their Roth IRA gradually each year, being careful to make sure their conversions are equal to their Standard Deduction.
In this situation, they are able to get money out of their 401(k)/Traditional IRA at a tax rate of 0%. You can’t get much better than 0%, so in this case, definitely do that shit. Build your Roth Conversion ladder, convert at 0%, wait 5 years, then withdraw tax-free.
SO WHEN DOES IT MAKE SENSE?
So that being said, why would MadFientist ever claim that it was a good idea to deliberately take a 10% penalty?
Because, it appears, he’s assuming that our early retiree has used up their Standard Deduction and is now being taxed at a marginal tax rate.
This is evident in a lot of his math, as he states that in his test case, his subject is taxed at a 15% marginal rate. This is not a retiree who is sitting around doing nothing, but rather a retiree who has decided to start a bit of a side hustle and has earned enough money to eat up their Standard Deduction.
This is also, as it turns out, the situation that last week’s reader case plans to be in.
So MadFientist is not wrong. At all. Rather, he’s actually surprisingly relevant to our reader case!
But I’m still suspicious of his claims that it EVER makes sense to voluntarily take the 10% penalty. But rather than sit around and speculate, let’s see where the math takes us, shall we?
To understand this phenomenon, let’s look at 3 scenarios:
Scenario 1: Roth Conversion Ladder
Assume we have a retiree who’s quitting at 40 years old. She has a $100,000 portfolio, is making $12K/year in side-income, and she plans to withdraw $10K each year.
Normally, your income drops to 0 in retirement, so you’ll be able to convert your Traditional IRA to a Roth tax free because you can shelter $12K/person within your standard deduction.
But in this case since this retiree’s side income is taking up her standard deduction room, she won’t be able to do the Roth Conversion ladder tax free (Wahh. First world problems, I know).
So if she were to convert 10K/year from her IRA, her taxable income would be $22k. I put this into a tax calculator, and it spit out that she would owe $1010 in taxes.
Over 5 years of implementing the ladder, she’ll have paid $1010 x 5 = $5050 in taxes. We’ll also have to factor in the investment gains they’ve forgone because this money went to the government instead of stayed in their IRA.
That means her portfolio at the end of the 5 years and using a conservative 6% return rate, her portfolio looks like this:
Scenario 2: Withdraw with Penalty
But what if she didn’t build the IRA ladder? What if she immediately withdraws the money right at 40 when she quit her job? She would be paying the same taxes: $1010/year plus a 10% penalty on the 10K she withdraws.
After 5 years, this is what her portfolio would look like:
Since she had to pay the extra 10% each year and she’s missing out on the returns earned on this money, this portfolio is $5975.32 less than if she had built the conversion ladder in scenario 1.
Scenario 3: Wait 5 years, then Withdraw
But, what if she were to wait 5 years letting the money compound tax-free before withdrawing it with a 10% penalty like the scenario in MadFientist’s post?
Wowee, right? This strategy seems to take the cake! Of course you would to this, right? Look how much up-and-to-the-right that grey line is compared to the rest of them!
Not so fast.
Because this is only a snapshot in time. This doesn’t show the whole picture because it’s in year 6 that she would start getting hit with the 10% penalty every time she withdraws, and those penalties keep hitting her forever. Let’s see what this does to her withdrawals over time.
Boom goes the dynamite. While the moment at the 5-year mark might make the Wait-and-Withdraw method seem like it wins, over the long term the continuous drag of the 10% early withdrawal penalty takes its toll. As we zoom out to a 30 year retirement, this drag overtakes these gains.
And of course Scenario 2 comes in dead last, because obviously if you withdraw right away, you get hit with the taxes AND the penalty. No bueno, so don’t do it.
BUT THAT’S NOT ALL…
Now, that’s all well and good, but I was curious and thought, “does this effect change depending on the tax bracket?” So that’s what I tested.
By sweeping the tax rates, I found something rather interesting: a situation where it DOES make sense to voluntarily pay the 10% penalty.
Here’s the two strategies of the Ladder vs. Wait-and-Withdraw charted out on a 10% tax rate.
Now here it is again at the next federal tax bracket, 12%.
See that? Where the Roth Conversion line dips lower and takes longer to come up and overtake the Wait-and-Withdraw line? That’s because the added effect of taxes reduces the amount of money available early on. And because there’s less money up front, there’s less to compound. And because there’s less to compound, there’s less to compound. And so on.
At 24% tax bracket:
At 32% tax bracket:
When you retire and earn money in a low tax bracket like 10% or 12%, even though it seems like Wait-and-Withdraw is beating the Ladder at the beginning, Ladder comes roaring back in the long run as all those 10% penalties add up over the years.
BUT if your side hustle is SO successful that you end up in a high tax bracket (>24%) right from the get-go, then Wait-and-Withdraw actually WINS. The effect of your portfolio being hammered by high taxes early on has such a negative effect on the long-term compounded gains that Ladder NEVER catches up to Wait-and-Withdraw. So in this case, it actually does make sense to delay your withdrawals and instead voluntarily pay the early withdrawal penalty.
Math Shit Up, yo!
So whether it makes sense to use a Ladder or Wait-and-Withdraw with the penalty is dependent on two factors: Your age and your marginal tax bracket at retirement.
For most people reading this blog, the correct answer is to use the Ladder. This is because the typical early retiree (if there is such a thing) will have a lower tax bracket at retirement and have such a long retirement timeframe that the Ladder strategy will eventually overtake the short term bump that Wait-and-Withdraw gives you.
But there are two specific groups of retirees that shouldn’t bother with the ladder.
The first is older retirees. If you’re in your 50’s, don’t bother with a Roth IRA ladder. You won’t have that long until you hit 59 1/2 and by then the penalties go away anyway.
The second is early retirees with ridiculously successful side hustles. If after you retire, your side hustles push you into a high enough tax bracket ( >24%), you’ll end up paying way too much tax during the first 5 years and in that specific case, it makes more sense to wait 5 years, then start withdrawing and paying the 10% penalty over time. That being said, making too much money in retirement doing what you love is the definition of champagne problems, so I wouldn’t cry too much over these poor souls.
What do you think? Are you going to use the Roth Conversion Ladder or just withdraw and take the 10% Penalty?
Playing With FIRE documentary is available on iTunes and ready for pre-order!
A lot of readers have asked me where can they access the Playing with FIRE documentary online. Well, guess what? The wait is over! You can get it on iTunes here.
For those who don’t use apple products (what is wrong with you? seriously?), you can also get it from Vimeo here.
The director and producer Travis Shakespeare (yes that is his real name, I asked) and Scott Rieckens have been working hard to spread the FIRE for the past 2 years, so let’s show them some support! Rate the movie on iTunes after you finished watching.
And as a teaser, here’s a clip of yours truly from the movie. I’m a movie star! Wheee!
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