In the movie classic “Animal House,” the Delta Fraternity was called in front of the Interfraternity Council accused of conduct unbecoming a fraternity. While the charges are being read, the following dialogue takes place between Otter, Delta’s Lothario; Hoover, Delta’s President; and Boon, Otter’s best friend:
Otter: “Point of parliamentary procedure!
Hoover: “Don’t screw around. They’re serious this time!
Otter: “Take it easy. I’m Pre-Law.
Boon: “I thought you were Pre-Med.
Otter: “What’s the difference?
The difference for one person making a bad financial decision was $87,000 in additional taxes. Here’s the story: An individual was retiring from their job and needed $70,000, $40,000 to purchase a new truck and $30,000 to cover medical bills. He (for simplicity sake, I’ll assume the individual is male) withdrew his entire $250,000 from his 401(k) which represented a 100% taxable distribution. This brings up a number of questions:
- Why did he withdraw his entire 401(k)?
- What is he going to live on during retirement?
- Why didn’t he consider the tax consequences?
- Why did he purchase a $40,000 truck when maybe a $20,000 truck would suffice?
By withdrawing his entire 401(k), he must now pay taxes on the entire $250,000 plus his salary for the portion of the year he worked before retirement and any social security benefits. That will significantly increase his tax liability which reduces the net savings he has to live on for the rest of his life. With a smaller savings base, he should be careful how the money is spent. Is a $40,000 truck really necessary? Unless the truck is used for business purposes to generate income, the purchase doesn’t make financial sense.
An alternative solution would have been to rollover his 401(k) to an IRA and only withdraw the minimum amount he needs for medical bills and basic living expenses. There would be no tax consequences for the remainder of the funds until they are withdrawn. In this case, the taxes would be based on just the amount withdrawn plus other income and government benefits.
I’m constantly thinking about how much money I need to live in retirement and how that money will be spent. Sometimes, we make emotional financial decisions. When dealing with finances, emotions need to be put aside. A professional financial planner will take the emotion out of those decisions and assist in reaching your financial goals.