Quizmaster, Doug Hutchinson, presents his quiz for the month. Here, Doug provides a an example to show the cost of taking an early withdraw from your IRA.
Consider this Scenario:
Your friend Ken is entering a Fantasy Football tournament and is considering funding his entry fee by taking an early withdrawal of $2,000 from his Traditional IRA.
Assume Ken has a federal income tax rate of 28% and a state income tax rate of 6%. Assume Ken will face an early withdrawal penalty of 10% (there are certain situations where an early withdrawal can be taken without the 10% penalty, but for the purpose of this example assume that Ken faces the early withdrawal penalty of 10%).
Ken is 25 years old and is planning to retire in 40 years at age 65. Assume that his IRA will return 7% each year for the next 40 years.
What would be the total cost of Ken’s early withdrawal considering both the immediate penalties/taxes and the growth in his IRA that he will miss due to taking an early withdrawal?
Solution:
If Ken takes an early withdrawal from his IRA to fund his entry fee then Ken had better hope for an extremely lucrative payoff in his Fantasy Football Tournament because his early withdrawal will end up costing him over $30,000!
- On his $2,000 withdrawal, Ken will pay an early withdrawal penalty of $2,000 x 10% = $200
- Ken will pay a Federal Income tax of $2,000 x 28% = $560
- Ken will pay a State Income tax of $2,000 x 6% = $120
- So Ken will pay taxes and penalties of $200 + $560 + $120 = $880
Taking out $2,000 from his IRA means that the $2,000 in his IRA that is not growing at 7% per year for the next 40 years. The amount of foregone growth in his IRA from his $2,000 withdrawal is $2,000 x 1.0740 = $29,949
Taking an early withdrawal from an IRA can turn out to be extremely costly. In addition to the penalty and taxes, an early withdrawal means that you’ll miss out on the compounding of investment returns on the amount that you withdraw.
Check out another quiz from Doug's Quiz Corner!
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
The information presented by WrapManager, Inc. is general information only and does not represent tax or legal advice, either expressed or implied. You are encouraged to seek professional tax advice for income tax questions and assistance. WrapManager, Inc. does not advise on any income tax requirements or issues.
