The Break-Even Frontier for Early Withdrawals from a Tax Deferred Account

Prakash, Arun J.; Smyser, Michael W.
August 2003
Journal of Financial Planning;Aug2003, Vol. 16 Issue 8, p56
Academic Journal
This paper examines the effect of the early withdrawal penalty on tax deferred account (TDA) accumulations. The break-even frontier represents the length of time that a contribution must remain invested in the TDA in order to accumulate sufficient earnings on the tax deferral to exceed the early withdrawal penalty incurred. If the investment horizon is greater than the break-even frontier, then the TDA investment alternative will have a greater terminal value than the after-tax investment alternative after all applicable taxes and penalties are paid in full. It follows that the break-even frontier represents the minimum number of years that a contribution to a TDA must remain invested in the TDA so that an early withdrawal from the TDA of the contribution plus accrued earnings will have a greater terminal value, net of taxes and penalty, than the alternative of investing the contribution as a nondeductible after-tax cash flow. To illustrate the concept of the break-even frontier in practice, consider the case of an investor facing a marginal personal income tax rate of 27.5 percent and expecting to earn 11 percent annual return. The investor, in this case, must postpone an early withdrawal from the TDA for at least six years in order for the early withdrawal to outperform investing the contribution as a nondeductible after-tax cash flow.


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