Retirement

I was thinking about retirement accounts today, because obviously the success of this blog has enabled me to retire early.  One question that arose: does it ever make sense to take early distributions at the cost of taxes and early distribution penalties?  Wait?  When can that make sense?  Certainly, in a vacuum, you should never distribute retirement savings prior to retirement: $1,000 of retirement withholdings will only be about $300-500 after taxes and penalties, and you just gave up a bunch of money that would otherwise be earning some type of yield, rather than being in someone else's hands.

Do I need to tap into my retirement fund?

So that scenario is easy to quantify.  But in a world of tradeoffs and opportunity costs, there are definitely going to be other scenarios where it might make sense for you to distribute early.  Let's look at the most common one: you have some credit card debt and aren't paying it off for a while.  If you did have unlimited funds idling in your savings account generating 1% interest income annually, then you would be stupid not to pay off your AMEX, which could be pushing 18% interest expense annually (I'm keeping these percentages very simple for illustrative purposes).  If you did not pay that debt off, you'd be losing 17% a year on your capital for no reason.  Simple.  Then again, very few people have unlimited funds.

If you are on the opposite end of the spectrum and have no savings to speak of, and no sufficient earnings to pay down debt, that is the point at which you might consider dipping into a retirement account to pay off your debt (let's pretend that loans collateralizing your 401(k) do not exist).  Similar to the savings account example, your retirement account might be earning 7% a year vs. your debt costing 18% a year.  All you need to do is make sure your foregone net interest costs offset the taxes and penalties from distributing prematurely.  The important metric is the time period over which you don't pay off the debt.  At some point  after you hold the debt long enough (maybe in 10 years), the dollar amount of interest costs will be so high that you will have wished you dumped the retirement savings to pay that debt off.  So here is a very basic decision framework that will tell you, for every dollar of debt, the payback time above which you should be touching that nest egg:

1. Let a = retirement account balance
2. Let b = % penalty from early distribution (assume 40% for taxes and 25% for penalties, total of 65%)
3. Let y = % annual yield on retirement account (7%; and assume post-tax to keep the formula simple)
4. Let i = % annual interest on credit card debt (18%)
5. Let d = amount of debt
6. Let n = number of years of not paying off debt above which you should simply take retirement funds to pay the debt (this is the variable that we hope to solve for)
7. Conceptually, to distribute retirement funds early, the following equation must be true: [d(1+i)^n-d] - [a(1+y)^n-a] < ba (this states that the foregone interest costs over the given time period are less than the early distribution penalty; in other words, DISTRIBUTE!)
8. Remember that if you take the early distribution of "a," you receive (1-b)*a; this is thus the amount of debt you can pay off using the distribution proceeds, meaning d = (1-b)*a
9. Resubstituting and simplifying, you get a(1-b)[(1+i)^n-1]-a[(1+y)^n-1] < ba
10. Reduce this formula to: [(1+i)^n-1]-b[(1+i)^n)-1]-[(1+y)^n-1] < b
11. Then: (1+i)^n - b(1+i)^n - (1+y)^n < 0
12. Then: (1-b)(1+i)^n < (1+y)^n
13. Take the log of both sides to get: LN((1-b)(1+i)^n) <> LN((1+y)^n)
14. Then: LN(1-b) + n*LN(1+i) < n*LN(1+y)
15. Ultimately: LN(1-b) / (LN(1+y) - LN(1+i)) < n
16. In spreadsheet form, enter "b" into C2, "y" into C3, and "i" into C4, then calculate using the formula =+LN(1-C2)/(LN(1+C3)-LN(1+C4))
17. Using the assumptions from 2-4, we have n > 10.73 years

In other words, as long as you can pay off your debt in 10.73 years or less with savings or earnings for this scenario, you should NOT be taking anything out of your retirement account.  If you are in the unfortunate position of not having sufficient savings or earnings to pay down the debt in 10.73 years, then think about doing something.  Practically speaking, unless you have unusually light penalties for early distribution, a really bad money manager getting you no returns on your retirement fund, or ridiculously high interest rates on your debt, you probably shouldn't think about using your retirement money before it's time.  But it could happen...

This post is dedicated to Antonio Cromartie, whose spending habits and child support payments (despite his large salary) make him a candidate to evaluate the retirement account tradeoff.  You're welcome for the formula.

F-One