Have you experienced adverse financial effects due to the COVID-19 pandemic? If so, you may be tempted to look at your 401(k) savings as a resource you can fall back on in this emergency.
The CARES Act gives 401(k) participants some latitude for making emergency withdrawals from their plan balances if they've been hurt financially by the pandemic.
However, cashing out 401(k) money should be viewed as a last resort, because it's not a cost-free strategy.
This article covers what you need to know before you decide to cash out of a 401(k) plan to make ends meet. Topics include:
- Review of normal restrictions on 401(k) withdrawals
- How to cash out a 401(k) under the CARES Act
- How it may still cost you to cash out a 401(k)
- Alternatives to making a 401(k) withdrawal due to COVID-19
- How to minimize the damage of a 401(k) coronavirus withdrawal
While a crisis can force people to take desperate actions, thinking things through before making an emergency 401(k) withdrawal can help you avoid making a bad problem even worse.
Normal Rules for 401(k) Withdrawals
To help understand the costs of withdrawing money from a 401(k) plan and the extra latitude provided by the CARES Act, a good starting point is to review the rules that normally apply to 401(k) withdrawals.
Ordinarily, you can begin taking 401(k) distributions without a penalty once you reach the age of 59 1/2.
Withdrawing from a 401(k) plan balance before you reach age 59 1/2 results in a 10% tax penalty, on top of any ordinary income taxes that would be assessed on the amount of your withdrawal.
The CARES Act and COVID-19 401(k) Withdrawals
How does the CARES Act change the rules for 401(k) withdrawals?
The law provides a temporary window for people who've been financially impacted by the coronavirus pandemic to access their 401(k) plan balances.
Ordinarily, people under the age of 59 1/2 would be too young to take a 401(k) withdrawal without a tax penalty. However, that penalty is waived for withdrawals made during 2020 by people who have suffered adverse financial consequences from the coronavirus.
The law also provides a three-year window for paying back a withdrawal from a 401(k) without having the withdrawal included in your taxable income.
The CARES Act also temporarily loosened some provisions with regard to borrowing from a 401(k) plan.
First, it doubled the amount you can borrow from your 401(k) balance. For 2020, you can borrow up to $100,000 against your plan balance, assuming you have at least that much in the plan.
Also, if you had a 401(k) loan outstanding prior to the passage of the CARES Act, you can delay some payments on that loan. Payments on any existing loans that were due between March 27, 2020 and December 31, 2020 can be postponed for up to one year.
The Costs of Cashing Out Your 401(k)
While the extra flexibility of the CARES Act might come in handy to people who are having money problems due to the pandemic, taking an early distribution from your 401(k) is still not a cost-free strategy.
Here are some of the ways it could cost you:
- You will still owe ordinary income taxes on the withdrawal unless you pay the money back into the 401(k) plan within three years.
Be especially careful to prepare for this. If you are unable to put the money back within the time limit, you will owe taxes on it. This may create a new financial hardship if you've already spent everything you withdrew from your 401(k).
- If the withdrawal counts as ordinary income, it could bump you into a higher tax bracket.
Be careful about how much you withdraw because the tax you owe if you can't pay it back within three years may be at a higher rate than you're used to. That's because the withdrawal amount would be added to your taxable income.
- You will miss out on potential investment gains for as long as your money is out of the plan.
A key to how a retirement plan like a 401(k) works is by helping you invest for the long term. You undermine that if you take money out of the plan even temporarily. That would leave you with fewer years of compounding investment returns.
- Trying to pay the money back is likely to cut into your future 401(k) contributions.
Even if you come up with the cash to put the money back into your 401(k) plan within the three-year window, doing so is likely to cut into the 401(k) contributions you would normally have made in those years. This would mean less money going into your plan in the long run and possibly missing out on some employer matching contributions.
Bottom line: Despite the CARES act, access to your 401(k) balance due to COVID-19 is not free. There could be both immediate and long-term costs to it.
Alternatives to Taking Money Out of a 401(k)
So if you are strapped for cash due to the COVID-19 pandemic and the resulting recession, what alternatives do you have to early 401(k) withdrawals?
Making an early withdrawal from your retirement plan should not be your first option. Below are some alternatives you should consider first.
Suspend your normal contributions
If you've been making routine contributions to your 401(k) plan, see if you can halt those for the time being. This would put some extra cash into your weekly paycheck.
Taking time out from 401(k) contributions is not ideal. It would stall your retirement savings and could mean missing out on some employer matching contributions.
Still, this is a less drastic step than withdrawing money that's already in your 401(k) plan. It would allow you to avoid reducing the amount you currently have invested and shield you from the potential tax consequences of not paying the money back within the three-year period.
Apply for financial relief from creditors
If you are struggling to repay loans or make other payments, see if you can get some relief from your creditors before you dip into your 401(k).
Many creditors recognize that the pandemic means they are going to have to show extra patience if they are going to get paid.
For some debts, like federally-sponsored student loans, there are formal programs that can give you more time to repay. For other debts, you may have to work out a special payment program.
The key is to work with your creditors rather than hide from them. They will generally be more flexible if they believe you are making a good-faith effort to pay them in the long run.
Extending your debts is probably not a cost-free solution either. It is likely to mean paying more interest in the long run. However, this could be a much cheaper solution than taking money out of your 401(k).
Borrow against your 401(k) balance
As noted previously, the CARES Act increased the amount you can borrow against your 401(k), as long as you have a large enough balance.
This isn't ideal because it reduces the amount you have invested. Also, repaying he loan could eat into future contributions.
However, the one potential advantage of this over an emergency withdrawal is that it could give you a longer time period in which to repay without tax consequences. Be aware, though, that if you lose your job, you may have significantly less time to repay a loan against your 401(k).
How to Withdraw from a 401(k) with Minimum Damage
If you conclude that you have no alternative but to use the provisions of the CARES Act to make an early withdrawal from your 401(k), here are some tips on doing it the right way:
- Check to see if you are eligible for a withdrawal under the CARES Act.
You have to be able to demonstrate that you have been hurt financially due to COVID-19. Talk to your employer's benefits office about whether you qualify.
- Weigh your alternatives.
If possible, talk to your 401(k) provider or a financial advisor to get guidance on how to get through this crisis with a minimum of harm to your long-term finances.
- Make an emergency budget.
Figure out how much you can cut spending and what the minimum amount of money you'll need to see you through this crisis. If you have to make a withdrawal from your 401(k) plan, the idea is to first figure out the least amount you'd need to withdraw.
- Consider the impact on your tax bracket.
Once you've decided how much you need to withdraw, check what including that withdrawal in your taxable income would do to your tax bracket. That will help you understand the full potential cost of making this move.
- Beware of investment scams.
The Securities and Exchange Commission warns that people are promoting bogus programs for investing CARES Act withdrawals.
Be clear about this: Any emergency withdrawal from your 401(k) should be to meet essential expenses, not to make other investments. It is unlikely any investment scheme would be superior to the options on your current retirement plan menu, let alone offer the tax and employer match advantages of a 401(k) plan.
- Create a payback plan.
The CARES Act gives you three years to repay money taken out of your 401(k) without tax consequences. Before you take the money out, create a budget plan for how you will repay it within the time limit.
- Create a catch-up plan.
As described previously, an emergency withdrawal from your 401(k) plan could set your retirement saving back in a few ways. Create a plan for making larger contributions in the future to make up ground, including using catch-up contributions if you are age 50 or older.
The COVID-19 pandemic has created financial hardships that may call for drastic action. However, you should make no financial decision until you are fully aware of the costs.