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If you’re experiencing financial hardship as a result of the coronavirus pandemic, you may be wishing you could take some of that money out of the 401(k) plan you’ve contributed to diligently throughout your career, without paying a penalty. And the federal coronavirus stimulus law (also known as the CARES Act) includes a provision for you to do that. During 2020, people under age 59½ will not be charged the normal 10% penalty for early withdrawals if they take coronavirus-related distributions from their 401(k) accounts during 2020.
However, most financial advisers caution against withdrawing funds from your retirement plan if possible.
“It’s hard enough to put money into your retirement plan and retire on it,” says Jeff Corliss, CFP, managing director and partner at RDM Financial Group in Westport, Conn. “By taking it out prematurely, even if you don’t pay a penalty, you’re still missing out on the potential gains you would have had by leaving it in the account.”
The CARES Act provision gives retirement savers a new option for accessing cash during the current crisis, but take time to think it through before you start siphoning cash out of your retirement fund.
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Consider all your options
While the coronavirus pandemic and its economic fallout was impossible to plan for, taking money from your retirement account may not be the only way to deal with it. “If you have no other source of income, taking money from your 401(k) may be your only option, but it’s a great time to talk to your lenders or landlord and see what bills you can defer,” Corliss says. “A lot of financial institutions are willing to work with people right now.”
Losing income and managing illness, remote work and a dearth of child care options can be an emotional experience. But try to take a logical approach to your finances.
“It comes down to a cash flow management discussion,” says Bryson Roof, CFP, investment adviser at Fort Pitt Captial Group in Pittsburgh. “If income has been eliminated, the only thing you can control is the outflow of cash.” He has seen some clients who have already burned through their emergency funds as the crisis continues, and recommends investigating options to delay mortgage payments, student loan payments and other bills. Also, look at tapping into other accounts that may not have the same tax advantages as a 401(k), such as a brokerage account or investment account.
For many people, their largest assets are their homes and their retirement accounts, so it makes sense to look at those assets as sources of cash, Roof says. If you have equity in your home, taking out a home equity line of credit (HELOC) may be a low-interest way to access cash.
However, getting a HELOC takes time, and “a 401(k) is faster to access,” Roof says. “We view this as a last resort, but if it’s the only way to take care of your family, you may need to do it.”
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Understanding how the 401(k) distribution works
Typically, if you withdraw funds from your 401(k) account before reaching age 59½, you’ll be charged income taxes on the withdrawal as well as a 10% early withdrawal penalty. The CARES Act waives the early withdrawal penalty, but you will still owe income taxes on the amount you withdraw.
That means the amount you take from your 401(k) will be added to the rest of your income for 2020 and your total income will determine your tax rate for the year. However, the taxes you owe as a result of the 401(k) withdrawal can be paid over three years. And if, within that three-year period, you pay back to your 401(k) the same amount you took out, you can get a refund on the associated taxes. To get the refund, you’ll have to file an amended tax return after replenishing your 401(k).
If you want to take money from your 401(k) with no penalty, you have to qualify by showing that you’ve experienced financial hardship due to the coronavirus, Corliss says. Basically, you have to show that the virus has had a negative impact on your financial situation, such as a layoff, furlough or decreased hours, or that you, your spouse or dependent has been diagnosed with the virus, or you have been unable to work because you had no child care available due to the virus.
For those who take the hardship withdrawal, “there are no limits on how you use the funds,” Corliss says.
What are the true costs of tapping your 401(k)?
Even though the CARES Act waives the penalty and you may be able to even avoid paying taxes on a 401(k) withdrawal this year, doing so should be a last resort. That’s because “the biggest cost associated with taking a 401(k) distribution is not taxes, it’s the opportunity cost of missing out on the growth of those funds that could have compounded over 20, 30 or 40 years,” Roof says. “You’re missing the opportunity of growth on the market’s recovery.”
While the market is volatile at the moment, it will eventually recover, Corliss says. And when it does, having your money in your retirement account instead of in your checking account can give you a big advantage. “Markets can rebound quickly,” Corliss says. “If you miss out on the top 10 to 20 days of the rebound, that can hamper your long-term growth.”
Tapping into your 401(k) may be your only option right now—and if so, the CARES Act has made that option even more palatable. However, if you have other ways to survive the crisis, avoid raiding your retirement plan and keep it set aside for what it was originally intended—long-term growth to provide you with a financial safety net later in life.
Freelance writer Nancy Mann Jackson writes regularly about personal finance and retirement. Her work has also appeared in Entrepreneur, Fortune, CNBC.com and Working Mother. Follow her on Twitter.
