Early withdrawals and penalties

0:00- [Instructor] Trevor is 44 years old. He has a Roth IRA to which he contributed $30,000. The account is now worth $50,000. He withdraws $38,000 to pay for home renovations. His marginal tax rate is 22%. How much will Trevor owe in early withdrawal penalties and federal income tax combined?

0:23Pause this video and have a go at that. All right, so let's just remind ourselves before we even go into the second part, here we're gonna talk, in the second part, we're gonna talk about a traditional 401k. But just to remind ourselves, a Roth IRA is an IRA, where we pay the taxes before we put it in.

0:41Before we put it in. So these contributions right over here, these are post-tax dollars. And so when you take money out of a Roth IRA, you don't pay penalty or taxes on the money that you contributed. Now you could pay penalty and taxes, and you are likely to, unless it's special exceptions, like getting it for a house, and even there, there's a limit or a disability, you will pay the penalty and taxes before age 59 and a half.

1:11And if you haven't had this Roth IRA for at least five years, you will pay it on the gains. So if he's withdrawing $38,000, the IRS will assume that the first 30,000 of that was what he contributed. So he doesn't have to pay any penalty or taxes on that. He only has to pay it on the $8,000.

1:34So he's gonna have $8,000 and he's going to have to pay, I could calculate it several ways, but he's going to have to pay 10% penalty, early withdrawal penalty, because he isn't 59 and a half, and well, we don't know how long he's had the account, but he's not 59 and a half for sure.

1:51And then he's also going to have to pay 22% on that money. 22% on that money. So that's equivalent to $8,000 times 32% or 0.32, and we could get our calculator out for that. We'll do it right there. So we have $8,000 times 0.32 is equal to $2,560. Now let's think about this second scenario.

2:25So let's say that he had a traditional 401k instead. How much would he owe in early withdrawal penalties and federal income tax combined? Well, in a traditional 401k, the money that's sitting in the 401k is all pre-tax money. And so the IRS is going to say, "No, you're gonna pay penalty and taxes on everything you take out."

2:48So it's essentially going to be the full amount, $38,000. $38,000 times the 10% plus the 22%. So times 0.32 or 32%, which is going to be, get the calculator out for this one. 38,000 times 0.32, $12,160. Now some of you might say, "Hey, maybe the Roth IRA is always better because of this scenario."

3:20But remember, this is a very particular scenario, where you are withdrawing it early. And remember, the traditional 401k, Trevor would not have had to pay taxes on his money to put it in. So there's definitely benefits to the traditional 401k that this scenario doesn't fully appreciate.