Cashing out retirement accounts can make sense in certain situations but it can also be a costly move. On 2 separate occasions I have cashed out my retirement accounts for a total of $140k. These were terrible choices since there was no valid reason to do so.
In this post I want to discuss the process of cashing out retirement accounts and the tax & penalty implications. Let’s discuss when it could make sense and when it’s likely a poor choice.
Specifically, I’ll be comparing cashing out an account en masse versus taking out just enough for living expenses.
Alternatives to cashing out retirement accounts are:
- getting a 401k loan
- accessing retirement funds in case of disability
- withdrawing a certain amount during financial hardship
- building a Roth IRA ladder
- establishing SEPP
Early Withdrawal Penalties & Taxes
The congress makes all the tax decisions in the US and the IRS is there to enforce it. If you cash out your retirement account before the age of 59.5 then you must pay income taxes (federal, state) and a tax penalty.
Retirement contributions aren’t tax-free, they are tax-deferred. You get a deduction for the amount you contribute to your retirement account and thereby avoid paying taxes on that amount. After age 60 you pay those deferred income taxes depending on your tax bracket.
10% Tax Penalty
So regardless of when you access your retirement account, age 35 or 85, you will pay income taxes on that withdrawal. The only additional fee to consider is a 10% tax penalty for withdrawing money before age 60.
Cashing out $100k of your retirement account is the same as getting $100k of income. Therefore, you’d pay income taxes on that income. That’s both federal and state income taxes.
You wouldn’t have to pay payroll taxes – that’s medicare and social security.
Why Cash Out Retirement Accounts?
Obviously, you’d cash out a retirement account because you need the money. Fortunately, there is no pro rate rule. You can just cash out $10k or you can cash out your entire nest-egg.
If you decide to retire early and use the profits from your investments to live off of then you would need to cash out the retirement accounts and move the money into a private brokerage.
The IRS will allow you to invest your retirement funds into all sorts of stuff, even real estate. There is only a small of list of things you cannot invest in.
Financial Cost Of Cashing Out Retirement Accounts
There are 2 ways one could go about cashing out their retirement account.
- cash it out all at once
- cash out a portion at a time
Let’s assume that an early retiree has $500,000 invested in their retirement accounts and another $200,000 in their private brokerage. The latter is easy to access. There would be some tax implications but hopefully the majority of it would be long-term capital gains (LTCG). LTCG is taxed much more favorably than wage earnings or short-term capital gains.
This early retiree doesn’t have enough earnings from that $200,000 to quit their job and they don’t want to lock themselves into a SEPP for the next few decades.
Cashing Out All Retirement Accounts
They have been investing for a decade. Their $350,000 investment over this time has grown to $500,000 in their retirement account. That’s a 43% return on their investment.
Cashing out the entire $500,000 would mean having to pay income taxes as well as the 10% tax penalty.
The income taxes would be calculated based on the progressive federal tax system. Depending on overall income for that calendar year, taxes on that $500k would be owed in a marginal fashion.
That comes out to a total of $150,000 owed in income taxes. The marginal tax rate would be 39.6% (highest tax bracket) but the effective tax rate would be around 30%.
On top of the $150,000 this person paid in income taxes, they would have state taxes to worry about and that 10% tax penalty which is applied to the gross withdrawal amount. That’s another $50,000 in tax penalties.
If there are state taxes to a tune of 10% then you would owe yet another $50,000.
Total tax bill: $250,000.
Tax rate: 50%.
Cashing Out A Portion At A Time
Let’s assume that you need somewhere around $40,000 to live off of in early retirement. Rather than cashing out the entire retirement account, you decide to cash out enough to cover your $40,000 annual income need.
If your retirement account balance is $500,000 and you withdraw $60,000 then you’ll have federal taxes ($8k), states taxes ($5k), and a 10% tax penalty ($5k).
Total tax bill: $18,000.
Tax rate: 30%.
A Sustainable Withdrawal Strategy?
Could a $500,000 retirement account sustain an annual withdrawal of $60,000? Quite unlikely.
It would depend on your rate of return. But taking out 12% ($60k/500k) every year would deplete your account quite quickly if you are invested conservatively.
If your retirement account was $1.5 million and you withdrew $60k a year from it then it would be much more likely to succeed. The withdrawal rate is around 4% which should be sustainable by your investments.
Because our taxes are progressive with steadily increasing marginal tax brackets, it wouldn’t make sense to take a lump-sum withdrawal.
However, if one needs access to their retirement accounts early then taking gradual annual withdrawals could make sense as long as the retirement account balance is large enough.
Alternatively, consider a SEPP which is a perfectly viable alternative to either of the methods above.