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4 good reasons for not tapping your IRA

Dear Dollar Diva,
I left my job and put the funds from my 403(b) plan into a "rollover" IRA. What would I end up with after taxes and penalties if I withdrew the entire $4,500 balance? -- Krista

Dear Krista,
Before the Diva answers your question, she wants to make sure everyone knows what a 403(b) plan and a "rollover" IRA are.

403(b) plan: A 403(b) plan is a tax-deferred retirement plan sponsored by nonprofit organizations. It's very much like the 401(k) plans sponsored by for-profit companies; both can be rolled over into a "rollover" IRA when employees leave their jobs.

"Rollover" IRA: A "rollover" IRA is a traditional IRA with a twist. The IRS conceived it as a conduit account for holding funds from precious employer-sponsored retirement plans until they were rolled over into another qualified retirement account, such as a traditional IRA or a future employer's 403(b) or 401(k) plan. There's no limit to how long you can keep the funds in a "rollover" account, you just can't make future contributions to it.

If you love your new employer's plan, go ahead and make the rollover; if not, leave it alone or roll it over into a traditional IRA if you want to make additional IRA contributions to it in the future. Either way, you win; you only lose if you withdraw the funds and cheat yourself of years and years of compound, tax-deferred earnings.

Why shouldn't I tap my IRA?
The cost of tapping your IRA far outweighs the benefit. Here's why you shouldn't do it:

  • Income tax
  • Early withdrawal penalty
  • Opportunity costs
  • You'll hate yourself in the morning

Income tax and early withdrawal penalty
You'd have to pony up the income tax when you file your taxes, and pay a 10 percent penalty, to boot, if you're younger than 59 1/2. Depending on your tax bracket and assuming that you'd get hit with the penalty, here's how much you'd end up with in your pocket if you cashed in your $4,500 IRA:

Early IRA distribution in amount of $4,500
Tax bracket
Net proceeds after tax
and 10-percent penalty
(1)
15.0%
$3,380
27.5%
$2,810
30.5%
$2,680
35.5%
$2,450
39.1%
$2,290
(1) Rounded to nearest zero

If your filing status is "single," taxable income of $65,550 would push you into the 30.5 percent tax bracket. Your tax and penalty would be $1,820, and your net "in your pocket" proceeds would be $2,680 (see chart above).

Here's a breakdown of the taxes and penalties at the various tax rates:

Federal income tax and 10% penalty at various tax rates
Income tax rate
Federal income tax (1)
+
penalty (10%)
=
Total tax and penalty
15.0%
$670
+
$450
=
$1,120
27.5%
$1,240
+
$450
=
$1,690
30.5%
$1,370
+
$450
=
$1,820
35.5%
$1,600
+
$450
=
$2,050
39.1%
$1,760
+
$450
=
$2,210

To get an idea of what your top tax rate is, go to the IRS Web site and take a look at its Revised 2001 Tax Rate Schedules. If the IRS schedule gives you a facial tic, try the Diva's simplified tax rate chart.

Opportunity costs
Tap the $4,500 in your 403(b) plan and you lose the opportunity to enjoy tax-deferred, compound earnings for a very long time. According to the U.S. National Vital Statistics Report's life-expectancy table, if you're 20 years old, you can expect to live for another 58 years; if you're 30, another 48 years and if you're 40, plan on having 39 more years to live, love and invest. That's a lot of time for your $4,500 to grow.

Using the Rule of 72, a 10-percent return doubles your money about every seven years. For more on the Rule of 72, read the Diva's "Impact of saving early."

That means at 10 percent, your $4,500 will double to $9,000 in seven years, $18,000 in 14 years and so on and so forth, growing to $576,000 in 49 years.

10% interest doubles every 7 years
Amount
Number of Years
(approximately)
Year
$4,500
0
2001
$9,000
7
2008
$18,000
14
2015
$36,000
21
2022
$72,000
28
2029
$144,000
35
2036
$288,000
42
2043
$576,000
49
2050

Ask any grandfather how fast 49 years can go when you're living a life.

You'll hate yourself in the morning
You're net ("in your pocket") proceeds after taxes and the nasty 10-percent penalty will be somewhere between $2,290 and $3,380. You'd be trading a small short-term gain today for large long-term benefits when you retire.

Let that $4,500 grow for a bunch of years, and the net proceeds could help fund winters in Florida, vacations to faraway places and plane tickets for the grandkids. If the price of tapping that 403(b) is having to give up these pleasures year after year, you'll surely hate yourself in the morning.

DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting, from the Kellogg Graduate School at Northwestern University in Evanston, Ill. Rosen has more than 15 years of experience in the financial arena, serving in Illinois and Florida as a certified public accountant, financial consultant, expert witness and educator. She is owner of Dorothy Rosen, CPA, a public accounting firm that serves individuals and small businesses.

Bankrate.com's corrections policy-- Posted: Dec. 6, 2001
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