Whether it’s sports, taxes or life, we’re programmed to avoid penalties — and usually that’s a good move. Occasionally, however, by simply avoiding penalties, we can be detrimental to ourselves. Indeed, sometimes incurring a penalty on purpose can be the right move.
A Lesson From Jim and Jane
I recently met with Jim and Jane. They were, in many ways, a typical couple in their 40s. Both Jim and Jane had good jobs and were making a nice living. But between paying for the mortgage on their home and raising their three children, they were pretty much spending every dollar that they were bringing in.
As I continued to talk with Jim and Jane, I was presently surprised at how much the couple had already managed to save for retirement. It turns out Jim had been a pretty good saver early on, and had already accumulated about $200,000 in his 401(k), and another $40,000 in a traditional IRA. Jane also had an IRA worth about $30,000.
When I asked Jim how he was able to accumulate as much as he had ahead of schedule, when he was just managing to get by, he told me that things weren’t always this way.
Jim said that before he and Jane had children, they lived in a smaller home and were able to save sizeable portions of their salaries each year. That, plus the generous match offered by Jim’s 401(k) plan, had gotten them to this point.
Now, however, with things being tight, Jim had stopped contributing to his plan all together. When I asked why, Jim told me that if he continued to defer from somewhere else to pay his bills and that the only resources he could tap was $35,000 in a savings account (which he was adamant about not touching, unless it was an emergency) and his IRA. He continued on, saying that when he asked his CPA about taking distributions from his IRA, his CPA told him that he shouldn’t take them — unless he had no where else to turn. Given Jim’s young age, those distributions would be subject to both regular income tax and a 10% penalty.
Intuitively, that made a lot of sense. After all, we’re programmed to avoid penalties.
But, thinking back to when Jim mentioned his 401(k) generous match, the wheels in my mind began turning. I came to learn that Jim’s employer was willing to match Jim’s contribution dollar-for-dollar up to 5% of his salary. Given his current salary of about $100,000, a $5,000 contribution from Jim would have netted him an additional $5,000 from his employer.
Instantly, I told Jim to resume making salary deferrals to his plan — and to defer enough to get his full employer match. “But if I do that,” said Jim. “I’ll have to take money out of my IRA, paying income tax and a penalty.” He was right, but we looked at the bigger picture.
If Jim were to defer $5,000 into his 401(k) plan, by virtue of his employer match, his contribution would be doubled and he would have $10,000 growing tax deferred. In addition, that $5,000 401(k) contribution would lower Jim’s income for this year by $5,000, allowing him to take $5,000 out of his IRA without increasing his regular income tax liability at all.
True, Jim would owe an additional $500 (the 10% penalty) by taking that distribution, which wouldn’t be cancelled out by his 401(k) contribution, but that $500 was essentially the cost of having $5,000 more in a retirement account growing tax deferred.
So, to sum it up, Jim has two choices:
- Continue to not contribute to his 401(k), keep his tax bill the same and not add anything to his retirement savings each year, or:
- Contribute $5,000 to his 401(k) plan, get the maximum employer match (another $5,000) and take a $5,000 distribution from his IRA. This would increase his tax bill by $500, but give him $5,000 more in a retirement account, growing tax deferred.
Although it’s important to have a general awareness of tax issues when contemplating retirement, there’s no substitute for consulting your tax advisor for advice specific to your individual situation. For Jim and Jane, it was an easy choice.
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