You might have heard that you may be able to take more money from your retirement savings to regain your financial footing because of the effects of the COVID-19 pandemic. The question is: Should you?
In March, the federal government passed a $2 trillion stimulus package called the CARES Act. Among other things, the legislation made changes to retirement plan rules to open up more options for people who are struggling.
Tax law generally restricts withdrawals from retirement plans for nonretirement purposes, except in certain emergencies. By including the pandemic among these covered emergencies, Washington recognized that many people need immediate help during this sudden economic shutdown.
That said, the withdrawals don’t come without cost to investors. Let’s look at some of the things you might consider as you think about taking advantage of these and other options.
Changes to retirement plan rules
The legislation included many changes, but three in particular can free up money for immediate use:
- Rules are loosened for withdrawals from 401(k) plans and IRAs. Plan sponsors can adopt a provision that allows people affected by the coronavirus* to take out up to $100,000 total from all retirement accounts, including IRAs. If you’re younger than age 59½, the 10% federal penalty tax that usually applies would be waived. The taxes you’d owe would be spread over a three-year period. In addition, you may avoid federal taxes on that distribution if you’re able to put the money back into your account or IRA within three years.
This type of withdrawal is not subject to a mandatory 20% federal withholding for taxes. State and local tax implications may vary, and we suggest you consult with a tax advisor.
If your plan usually charges a distribution fee for withdrawals, it will be waived for this coronavirus-related withdrawal.
- Plan loans are doubled. The law allows plans that offer loans to adopt a provision to double the amount that participants can borrow to $100,000 (if you have had a loan at any time during the past 12 months, the amount you can borrow is reduced by the difference between your highest loan balance over the past 12 months and your loan balance on the date your new loan is made) or 100% of the vested account balance, whichever is less. This is available until September 22, 2020. If your plan usually charges a loan origination fee, it will be waived. To be eligible, you must be affected by the coronavirus.*
- Loan payments can be suspended. If you already have loans, are affected by the coronavirus,* and your plan sponsor adopts this provision, you can suspend your loan payments for up to a year. Following the suspension period, the loan will be reamortized to include the missed payments and interest accrued during the suspension, and the length of time you have to repay the loan may be extended by the duration of the suspension (which can be up to one year).
To learn more about the CARES Act changes and the options it made available, please read New stimulus law offers assistance to retirement savers.
The need is real…
Tens of millions of Americans have filed initial jobless claims since March 14. That’s the largest rise in claims since the U.S. Department of Labor started tracking this data in 1967. The unemployment rate climbed to 14.7% at the end of April, up from 4.4% in March and a historic low of 3.5% in February.
Clearly, many people are struggling financially. The CARES Act could give some much-needed assistance to those scrambling to pay their bills after being laid off or furloughed. But the legislation is not a perfect solution.
First, it doesn’t help everyone. Only half of U.S. workers participate in a retirement plan at work, according to the Bureau of Labor Statistics. And of those who do participate, many have saved far less than $100,000, so they don’t have a lot to tap into during this emergency. This is especially true of younger generations who haven’t had the opportunity—professionally or economically—to make a lot of progress in investing for retirement or saving for emergencies.
Second, availing yourself of these options today may put your long-term goals at risk later on.
…And so are the consequences
Investors know the risks of using tomorrow’s retirement money today, and no one wants to have to go that route. There are good reasons to refrain from withdrawing your retirement savings (as opposed to borrowing) if you can. The biggest is that it could result in not having enough savings when it’s time to retire. Making up this shortfall might mean having to increase your future contributions considerably or working significantly longer than you had intended.
Then there’s the issue of bad timing. If you’re predominantly a stock investor, the market value of your retirement fund has probably fallen, starting with the swift market decline of March. So if you withdraw your money now, you may be selling funds and locking in those losses at a low point.
History tells us that when markets rebound after a downturn, it typically happens fast. Withdrawing your retirement funds now may prevent you from benefiting from any rebound.
Loans may be a better option
If you are working and drawing a paycheck, borrowing from the plan may be a better strategy than withdrawing money. Here’s why: When you borrow from the plan, you automatically begin to repay the loan with every paycheck. The automatic nature of repayment makes it more likely that the borrowed money will be returned to your long-term savings. Yes, you can repay a withdrawal from the plan for up to three years under the new law, but it can take more discipline and foresight to do so.
The biggest risk of any retirement plan loan is that you won’t be able to pay the money back. If that happens, the unpaid balance is considered taxable income. You would owe ordinary income taxes and, if you are under age 59½, there is a potential 10% early withdrawal penalty tax as well. The tax burden could be significant, and that could take a serious toll on your savings.
Hard times call for tough decisions
In times like these, it may seem like there are no good options, but only some options that are less bad than others. The best thing you can do is be informed, assess your situation realistically, and act thoughtfully. Make the choices that make the most sense for you and your family. Because you know that retirement savings should be used as a last resort—even in emergencies—perhaps there are options you could consider first.
The CARES Act contains many aid programs that are pushing billions of dollars into the economy for those who have lost jobs or have reduced hours at work. If you qualify for them, many of these programs provide cash that doesn’t have to be repaid. So filing for unemployment benefits may help you weather the storm.
If you can’t pay your bills, be sure to contact your creditors and lenders. Many of them have implemented forbearance programs that allow people to skip payments for now, while so many Americans are unable to work.
As in any period of economic uncertainty, many people are also tightening their belts, looking for ways to spend every dollar as effectively as possible. If you have a home mortgage, for example, you might consider shopping for a lower rate while interest rates are at historic lows.
If these suggestions don’t help—or don’t help enough—and you need to dip into your retirement savings, go ahead and do so. Here are some strategies to help you follow this path thoughtfully:
- Start small. While your plan sponsor may allow you to withdraw up to $100,000 (or 100% of your vested balance), you may not want to take out so much at once. Check your plan’s rules to see whether you can request additional withdrawals or loans if you need them.
- If you have a loan, suspend the payments. Remember: The legislation allows you to suspend loan payments for up to a year if your plan sponsor adopts the provision that allows it. Not only will you have up to an extra year to pay back your loan once payments resume, but you’ll have extra money in each paycheck over the next year to help with current financial obligations.
- Remember to plan for how you’ll repay yourself. The CARES Act allows you to tap into your retirement accounts without penalty taxes and repay the money over three years. Your ability to access money for the short-term needs of today but pay yourself back is important. It means you won’t owe taxes on the money and you also won’t wipe out your hard-earned, long-term retirement funding.