In planning how to finance a large purchase before age 59 ½, it’s common to consider the idea of taking a withdrawal or a loan from a 401(k) or another retirement account. Taking money from your retirement funds is not a decision to be made lightly and can come with a few negative consequences. But the Coronavirus Aid, Relief and Economic Security (CARES) Act has allocated $2 trillion for economic stimulus and relief, including provisions to make it easier and more sensible for some to access their retirement funds.
If you’re experiencing hardship because of the Coronavirus pandemic, you may be considering borrowing or withdrawing money from your 401(k) to help. Some things to consider:
What Has Changed Under the CARES Act?
Normally, you can withdraw or borrow up to 50% (or $50,000) from your 401(k) savings before age 59 ½. A premature withdrawal usually comes with a 10% penalty and at least 20% automatic withholding from taxes.
Under the CARES Act, you can now borrow or withdraw up to $100,000 from employer-sponsored and personal retirement accounts, or a combination of the two. The 10% penalty is waived for distributions made in 2020 and there are no mandatory withholding requirements. However, if you don’t pay back the amount you withdrew, the distribution will be taxed as income. You can spread this evenly over the years 2020, 2021 and 2022. If you do pay back the amount within three years, you can claim a refund on those taxes.
You can also take out up to 100% or $100,000 as a loan and defer payments for up to one year.
Who is Eligible?
Not everyone is eligible to take advantage of these 401(k) benefits. If you, your spouse or a dependent has been diagnosed with COVID-19, you are automatically eligible. Otherwise, if you have suffered from financial hardship due to the pandemic, you may be eligible. This could include a number of circumstances that you, your spouse or a member of your household has experienced, including:
- Being furloughed, laid off or under mandatory quarantine.
- Having work hours cut, income reduced, or a job offer rescinded or delayed.
- Being unable to work because of a lack of childcare.
- Being a business owner who has had to cut down hours or close a business.
Even if you are still employed, you may be eligible for a distribution from your 401(k) if you have had one or more of these hardships.
Consider Your Options Carefully
Consider the impact that a withdrawal from your account may have on compound interest over time. If you’re withdrawing with no plan for paying it back, you may be hurting your finances more in the long run than borrowing from somewhere else. But, especially if you’re experiencing a hardship like loss of income, withdrawing money from your 401(k) may make more sense than accumulating high-interest debt.
Be mindful of taxes in your specific situation. As mentioned above, you can claim your distribution as income all at once or spread it out over the next three years. In many cases, it would be better to spread the income out, as you’ll be less likely to bump yourself into a higher tax bracket. Although if you expect your income to be lower in 2020 than the two subsequent years, claiming the distribution all at once may result in a lower tax liability.
Conversely, taking a loan does not immediately count as income if you plan to stay with your employer; you will pay back the loan over the next five years. But staying with the same employer for 5 years isn’t always in your control. If you separate from that employer, the full remaining amount of your loan is due by mid-October of the following year. If you do not pay the loan back by then, the entire amount is considered an early withdrawal, and is therefore taxable and will incur a penalty.
Retirement plans are designed for long-term savings to help you save for your post-working years. There are serious consequences to withdrawals and loans, and they should be considered very carefully.
If you’re struggling to figure out whether taking a withdrawal or loan from your 401(k) is right for your needs, consult a financial professional to figure out what your best plan of action may be.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice .We suggest that you discuss your specific tax issues with a qualified tax advisor.
