The IRA Penalty: Sometimes It’s a Small Price to Pay

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The human condition drives people to avoid penalties with all their might. From sports to taxes, dodging fines is simply in our DNA. But sometimes, Kevin Canterbury of Arizona says paying can be worth it to increase assets and secure a wealthier future.

Investment-hungry individuals realize the potential of incurring an IRA penalty on purpose. The trick appears to be paying at the right time, as showcased by this middle-aged couple, Grant and Wendy.

A Brief Background

Grant and Wendy were a run-of-the-mill couple in many ways. They earned decently, but everything they made fluttered away to pay for three children and a mortgage.

Despite that, the couple was diligent with their finances. Wendy had a traditional IRA worth $30,000. Grant had a 401(k) filled with $200,000 and $40,000 in an IRA.

When questioned, Grant stated he accumulated much of this wealth “ahead of time.” He mentioned, “Wendy and I used to live in a smaller home. It allowed us to save larger chunks of our salaries every year. Plus, my 401(k) plan came with a generous match offer, which has got us this far.”

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The IRA Penalty Debate

However, the couple’s situation shifted. As their economic environment became tighter, Grant stopped contributing to his 401(k) plan.

When speaking to a financial planner, he stated that continuing to contribute would force him to take money from elsewhere to pay the bills. Ultimately, he didn’t want to touch his $35,000 savings account unless it was an emergency. After that, the only other place he could tap into was his IRA.

So, Grant contacted his CPA to discuss accessing the money held in the IRA but was quickly put off by the idea when told the distributions would be subject to a 10% penalty and regular income tax.

And thus, the IRA penalty debate begins.

Innately, the decision to avoid the penalty makes sense. However, they were missing a potentially substantial wealth-building trick:

Restart 401(k) Contributions and Pay the IRA Penalty

When advised to restart $5,000 salary deferral contributions per year (matched by Grant’s company), he was initially distraught — the thought of paying income tax and a penalty on his IRA distributions was simply too much.

But by taking a step back and looking at a longer-term picture, all became clear.

The deferrals lowered his income, ensuring his IRA distributions did not affect his income tax payments. Plus, he had an extra $10,000 in his 401(k) growing tax-deferred. True, he owed a $500 penalty that wasn’t canceled out by the 401(k) contribution. However, he began to view that as the cost of having a larger retirement fund.

The trade-off is marvelous.

The Crux: Thinking Big

Estate planning, penalties, and taxes aren’t black and white. So while a general understanding of big-picture tax issues is essential, avid retirement savers should consult a financial advisor to determine whether purposefully paying the IRA penalty makes sense.

Many believe taking pre-59 distributions is never a good idea. But Grant and Wendy’s situation highlights that the word “never” doesn’t apply to paying the IRA penalty. 

Kevin Canterbury
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