写在前面：最近做了一些研究，写了一个关于retirement account early withdraw的小短文，因为很多东西不太好翻译成中文，相信地里大部分的人也不会介意看英文的。希望能够给大家提供一些信息。 Disclaimer
Do your Own Research. The content is intended to be used and must be used for informational purposes only. It is very important to do your own analysis before making any investment based on your own personal circumstances.
Motivation
Earth withdraw your fund from most retirement accounts will result in penalty and/or income tax. I don’t find a comprehensive article deep-diving into common scenarios and crunching the number. Thus, I decided to figure it out myself.
Before crunching the numbers, a little bit about the reason behind early withdraw. Some people (like me) don’t see themselves retire at 60 in the US. For example, people may choose to move to another country or move back to their home country. As a consequence, all retirement accounts can’t be maintained because you are not live and work in the U.S. Though, I haven’t consult any financial advisor / legal about the potential solution keeping those accounts, it’s better to explore sooner than later on all options which includes the early withdraw to avoid suboptimal investment decision and potential asset loss.
Assumption
Everyone is different in their financial situation. For simplicity purpose, we assume investing the maximum pre-tax money 19500 (or after-tax 13260) to different accounts to align the input across different scenarios listed below. We also assume your invest portfolio rate of return is uniform at 7%.
We also assume the investment horizon with early withdraw is 10 years and your income tax bracket is the same 32% throughout the time.
Common Scenario
Scenario 1: Invest in a traditional 401k with company match
Invest 19500 (maximum in 2021), company matches 3.5% of your annual eligible pay assume it’s 250000*3.5%=8750. Thus, the total contribution at the end of year 1 would be 19500+8750=28250 in your pre-tax 401k account. Exp ratio of funds in pre-tax 401k are around 0.02%~0.05% which is low enough and can be ignored. Here I don’t take tax withholding 20% into account since it will eventually converge to your income tax bracket that year. Here I assume you will max out your contribution at the beginning of the year, and match will be also maxed out at the same time. While in reality, most of company won’t be able to do that.
While you withdrawing your money, you need to pay 32% income tax and 10% penalty:
If there is no company match:
19500 * (1 + 7%) ^ 10 * (1 - 32%) * (1 - 10%) = 23475
In this scenario, one doesn’t need to do any conversion among accounts, the only hassle is when pulling the money you may face a bit complex tax situation and 10% penalty. I will rate the hassle level at 2.
Scenario 2: Invest in traditional 401k with company match, rollover to a Roth IRA after 3 years when leaving the company
Same as Scenario 1, at year 1, total contribution is 28250. It will grow at 7% return for 3 years.
28250 * (1 + 7%)^3 = 34607
When rollover it to a Roth IRA account, one needs to pay tax at 32%
34607 * (1 - 32%) = 23533
The remaining 7 years, the same return rate 7%.
23533 * (1 + 7%) ^ 7 = 37789
Since it’s been a 7 years since the rollover, the initial contribution is considered tax and penalty free. However, the earnings needs to pay tax and 10% penalty (if not 59.5):
This scenario requires one rollover which will lead to tax implication, and when pulling out money from the Roth IRA, there is another round of tax/penalty hassle. I will rate the hassle level at 4
Scenario 3: After-tax money contributes into traditional IRA, then backdoor rollover to Roth IRA
In order to compare with other scenarios, I assume the total fund will be the same as 19500 * (1 - 32%) = 13260. This takes 3 years: 6k at year 1, 6k at year 2. 1.26k at year 3.
Since contributions are all after-tax money, they should be considered non-taxable events during conversion to Roth IRA. When distribution happens, the initial contribution 13260 will be no tax, no penalty but earnings will be taxed and penalized.
This scenario requires three conversions to avoid much complex tax implication (avoid earnings in traditional IRA). When pulling out the money, it’s at the same level as scenario 2. Thus, I will rate the hassle level at 5 (maximum).
Scenario 4: Invest in a after-tax 401k, in-plan rollover to Roth 401k (then rollover to Roth IRA)
Since there is no match for after-tax 401k, thus initial contribution would be 19500 * (1 - 32%) = 13260
Since it’s all after tax money, it will not cause any tax whenever doing in-plan rollover or rollover from Roth 401k to Roth IRA for contribution. However, it’s worth noting there is some complication if you can’t do the in-plan rollover to Roth 401k and there is earning in after-tax 401k, which may cause more complex tax situation and I won’t go into details here. If you do the conversion from Roth 401k to Roth IRA, it’s a non-taxable conversion and the contribution can be pulled out ANY TIME without tax implication and penalty but earnings is still facing income tax and penalty. The same applies to not do the rollover to Roth IRA, Roth 401k early withdraw is facing the same tax and penalty for earnings while no tax/penalty for contribution. One thing to notice is Roth IRA distribution order is different from Roth 401k: Roth 401k early withdraws are prorated (more details (https://www.investopedia.com/ask ... ithdrawal-rules.asp)) while Roth IRA is following a certain order shown as below. If you withdraw all money, then it should be the same.
This scenario potentially needs one rollover with no tax implication, and pulling out money from Roth 401k/Roth IRA may also face the similar tax and penalty hassle as Scenario 1. I will rate hassle level at 3.
Scenario 5 - baseline: Invest in a taxable account
Initial contribution would be: 13260
Assume annual dividend of the portfolio is 2% and all considered qualified dividend tax rate 15%. Thus, actual return is 7% - 2% * 15% = 6.7%. Assume long-term capital gain tax rate 15%.
From financial perspective, we can clearly see from the results that maxing out pre-tax 401k with company match clearly win the gain (even with penalty) while maxing out pre-tax 401k without company match is around the same result as the baseline. Scenario 3 and 4 don’t make sense under early withdraw.
Before making a conclusion, another aspect I don’t mention much is different accounts can have various level of investment options and fees. For example, traditional 401k has less options while Roth IRA or taxable account have more options. I also don’t differentiate the rate of return for each scenario (except dividend tax mentioned in Scenario 5) assuming the same portfolio with the same rate of return, but in reality, it rarely holds true.
In summary, I will pick Scenario 1 and 5 because:
Scenario 1 and 2 are mutually exclusive. If you want to avoid any hassle, pick 1. If you want more investment options targeting higher rate of return, pick 2. In either case, max out contribution as early as possible if company can match your contribution no matter when you make contribution. If there is no company match or company match has to be paced month by month, pre-tax 401k is still a worth retirement account to put your money.
Avoid Scenario 3 since it doesn’t make any sense in terms of both return and hassle level.
As for scenario 4, due to early withdraw, tax benefits are limited, and I would avoid this as well.
For Scenario 5, I would first max out Scenario 1 and invest the rest into taxable account. We need to note short-term capital gain versus long-term capital gain since it will have huge impact on your decision choosing Scenario 5.
The following is showing overall rank for all scenarios.
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