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Congress has just passed the CARES Act, allowing people to borrow more from their retirement portfolio if they’ve been hit economically by the crisis.
“It’s basically doubled,” says Robert Neis, tax and benefits lawyer at the law firm Eversheds Sutherland, of the permitted loan limit. “Generally, you can only borrow up to 50% of your vested plan balance or $50,000, whichever is less, [but] for a plan participant who has been affected by COVID-19, the limit is increased to the lesser of 100% of the vested account balance or $100,000,” he says.
Meanwhile, the new law also waives the 10% early withdrawal penalty for those who take money out for good, although they’ll still have to pay income tax.
There are plenty of wrinkles. You have to apply during the next six months, Neis says. And only certain people can benefit from the new rules. “They are not available to everybody,” he says. “You have to be effected [financially] by COVID-19.” That includes being laid off, furloughed, or working reduced hours for reduced pay, he says. It also includes those who can’t work because they can’t get child care for their children.
But if you face an emergency cash crunch, should you borrow from you 401(k)? Or is it a disastrous mistake?
Ironically, Congress has made it easier to borrow from your retirement account just as it has become more dangerous.
Even in normal times, there are hidden costs to borrowing from your plan, financial advisers note.
First, you (obviously) reduce the amount you have invested for your retirement. In the current situation, when stock prices have been so heavily discounted across the board, that may be especially costly over the long term.
Secondly, you must repay the borrow money, plus interest, with after-tax dollars.
And third, if you don’t repay within the allotted time, generally five years, you are deemed to have taken an early distribution. In that case you’ll have to pay income tax on the money. (In ordinary times you have to pay a 10% penalty, too.)
On the other hand, in normal times there may be a good reason to borrow from your 401(k): Namely, if you really, really need the cash flow up front for a serious purpose, and you’d have to borrow it from somewhere anyway.
Paying yourself 5% (say) interest, even in after-tax dollars, sure beats paying 15% or even 30% to a bank or credit card company (also with after-tax dollars). The interest isn’t just lower on a 401(k) loan. You’re paying the money to yourself.
But that’s in normal times. And this is far from a normal time.
The biggest financial risk many ordinary people face now isn’t just a few weeks’ cash flow. It’s a prolonged economic slump, unemployment, and default or bankruptcy.
Mass unemployment has already begun and unless the health emergency turns around quickly it’s likely to get a lot worse before it gets better.
Personal bankruptcies skyrocketed after the 2008-9 financial crisis, even though Congress had just drastically tightened up the laws. In 2007, there were fewer than 500,000 chapter 7 personal liquidation bankruptcies.
By 2010 and 2011 the figure was over 1 million a year.
The surge in personal bankruptcies came after the economy started improving. Too many people just couldn’t get out from under all the debts they’d accumulated in previous years. Personal bankruptcies didn’t get back down to around precrisis levels until 2015.
And this is where the 401(k) becomes a golden asset. Lawyers point out: It is protected in bankruptcy proceedings.
“The general rule is that any qualified retirement plan is completely exempt from your creditors and the bankruptcy trustee,” says Richard Nemeth, a bankruptcy attorney in Cleveland, and a member of the board of the National Association of Consumer Bankruptcy Attorneys. “When you file for bankruptcy, it doesn’t matter how much money you have in your retirement account, the creditors and the bankruptcy court can never touch it.”
The exceptions, he adds, are rare: For example, an IRA inherited from a relative may be subject to creditors’ claims. This isn’t gaming the system, he adds. This is deliberate public policy, and is respected as such by the courts.
Congress actually tightened up the protections for retirement accounts when it reformed the bankruptcy laws in 2005, Nemeth adds. The federal government treats retirement plans as sacrosanct because if people can’t pay for their own retirements, the burden will fall on the taxpayers, he says.
Broadly speaking, bankruptcy allows people who can’t pay their debts start over, usually through liquidating their assets and working out payment plans with creditors. Bankruptcy laws also protect businesses in financial straits.
The current president has never filed for personal bankruptcy — but it’s a different story when it comes to his corporate entities. He’s said that his businesses have made ample use of the bankruptcy laws. “I have used the bankruptcy laws a few times to make deals better. Nothing personal, just business,” he’s said. Putting businesses into bankruptcy to get a better deal is “a very effective & commonly used business tool,” he added. Using the bankruptcy laws to squeeze or escape creditors is “smart,” he’s said on Twitter.
Today he says he’s worth $10 billion, but no one has required him to repay the defaulted loans from yesteryear. And that’s normal on Wall Street, where companies often use bankruptcy proceedings to escape—or “restructure” — their debts.
Bottom line? Borrowing from your 401(k) might seem a cheap source of money. But be aware of the risks. If the situation gets worse this “cheap” source of money may prove very, very expensive.
