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Financial laws are changing fast. Now you can even take money early from your retirement account without an immediate penalty. Should you? Not if you’re acting out of fear or panic. Here’s the fine print about early withdrawals from 401(k) and other retirement accounts, plus 5 questions to ask to make a smart decision:
Under the new federal rules, the 10% penalty for tapping your retirement account before you turn age 59 1/2 is waived for distributions up to $100,000. While this money is still considered income for 2020, you’re allowed three years to either pay the taxes or avoid taxes by fully restoring the funds into your retirement account. You’ll still have to file an amended tax return, and you must be considered a qualified individual under the CARES Act to make this move.
In general, using long-term money to pay off short-term expenses is not wise money management. Retirement plans are long-term sources of money. Plus, the resulting tax implications from your state and filing extra tax forms may discount much of any added benefit.
Consider other options to raise cash. Many people now qualify for unemployment compensation, and service agencies are helping with food and utilities. Stimulus checks may have arrived but there is talk of additional help from the government.
More: How to find a tax-smart way to finance retirement
Above all, it pays to be a harsh critic your current spending by reviewing your expenses in detail. Some suggestions:
• Keep only the absolute necessities as auto-payment on your debit card.
• Cancel subscription services and trimming entertainment expenses.
• Stop monthly automatic charitable donations. Give more later when you have more money.
• Get a refund for a planned vacation instead of postponing it.
• Pay your credit card bill over time by creating a plan with your credit-card company.
What if you feel you must take an early withdrawal from your retirement fund? If you believe you’ll be able to pay it back within three years, think again. Do you really know what your financial circumstances will be in one year, let alone three?
In addition, an early withdrawal will destroy the benefits of compounded growth of your investments over the years. The time value of money is priceless. Before you take a retirement withdraw, consider these five questions:
• Will this added income disqualify you for from other federal programs that may help you with housing or food benefits?
• If you intend to pay back the money, are you willing to repay the retirement funds with after-tax money? You will pay more in taxes to use this money now.
• How will this money impact your effective tax rate? Even a change from 10% to 15% means more of your money will be taxed.
• What is your retirement plan? Replenishing money that took multiple jobs and years to accumulate may mean working longer than you intended.
• Are you prepared to track this money for three years and potentially incur IRS debt?
Most importantly, if you do withdraw money now that was earmarked for your retirement, take as little as possible and set some funds aside for taxes.
CD Moriarty is a Vermont-based financial speaker, writer and coach. She can be reached through her website.
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