Whether it’s pride or fear, humans are generally averse to penalties. When it comes to our finances, though, it’s sometimes wiser to incur a loss in sight of greater gains than to play it safe and earn nothing at all. In the case of an employer-matched IRA, contributing a portion of your income and then deducting the added benefit can pay off more than leaving the account untouched.
Depending on the terms of the retirement account, it may be better to pay the IRA penalty to lower your financial burden while contributing more to your savings. To better understand when it makes sense to do so, Kevin Canterbury of Arizona looks at the specifics and discusses how smart savings can generate greater financial stability.
Contributing to a Dollar-for-Dollar Employer-Matched 401(K) Pays Off in Times of Financial Hardship
If you’re already contributing to a 401(k) with an employer match, you know that every dollar you contribute is effectively worth two. If you leave your job, you can still keep the money in the 401(k) and let it grow tax-deferred until you retire.
However, if you find yourself in a financial bind and need access to the money, you’ll face a 10% early withdrawal penalty in addition to income taxes on the money you take out. For example, let’s say you have a 401(k) balance of $30,000 but you’re struggling to make ends meet. Rather than contribute more to your IRA, you cease deductions and let it sit dormant.
While this may help to cover expenses, it would be in your best interest to pay into the IRA to benefit from the money your employee matches. If you were to contribute $2,000 and then withdraw the same $2,000 after your employer matches the sum, you would effectively increase your savings by $2,000 while only paying a $200 early withdrawal penalty (10% of $2,000).
Equal-Sum Deposits and Withdrawals Cancel Out the Burden of Added Income Tax
If you’re in a position to contribute a sum of money equal to what you’ll withdraw, you can effectively cancel the burden of the added income tax. For example, if you contribute $5,000 a year for 20 years while withdrawing $5,000 a year, you will have effectively paid the same amount in taxes regardless of whether you paid the penalty or not.
This is because the $5,000 you contribute each year is deducted from your taxable income for that year, and the $5,000 withdrawals are added to your taxable income for the year. So, if you’re in a 25% tax bracket, you would pay $1,250 in taxes on the $5,000 you contribute, and you would save $1,250 in taxes on the $5,000 you withdraw.
In this scenario, it would actually be better to pay the 10% early withdrawal penalty on the $5,000 you withdraw each year because you would save more in taxes than you would pay in penalties.
The Bottom Line
Paying the IRA penalty may not be ideal, but there are situations where it can make sense. If your employer is willing to match your contributions dollar-for-dollar, you can continue adding value to the retirement account without sacrificing financial stability. Although you will pay a small fee, your retirement plan and current account balance will benefit in the long run.