The coronavirus pandemic caused significant financial distress across the entire world. In the United States, the response included the $2 trillion CARES Act, which provided individual stimulus checks and made provisions to make it easier for people to take withdrawals and loans from their retirement accounts. Through the act, these withdrawals are exempt from the typical 10 percent penalty, provided that the withdrawals are repaid within a given timeframe. The IRS released formal guidance for taking withdrawals from retirement accounts in mid-June, and this document clearly outlines all rules and regulations about the policy change.
An Overview of the New Policy on Early Retirement Withdrawals
According to the CARES Act, anyone who has experienced an adverse financial consequence as a result of COVID-19 is eligible to make a withdrawal from their 401(k) plan, up to $100,000. In addition, individuals can take up to $100,000 in distributions from 401(k)s and IRAs. This latter cap is across all retirement accounts that a person might have rather than a limit for each different account.
Anyone who would normally face a 10 percent penalty for early withdrawals will see this charge waived for 2020. Individuals are still required to pay taxes on the amount that they withdraw, but they can pay the taxes over three years rather than immediately.
The other important piece of the recent legislation that you need to know is the ability to repay the distribution. You will have three years to repay the distribution you took from a 401(k), IRA, or another qualified account. This repayment is considered a rollover contribution. As long as the rollover contribution is completed within three years, the distributions are no longer subject to taxes.
You will need to complete and file an amended tax return to the IRS to process the rollover contribution and remove the tax burden. In some cases, however, this stipulation can save individuals a lot of money that would otherwise go to the federal government.
The Key Considerations about Taking an Early Withdrawal
Importantly, not everyone qualifies for penalty-free early withdrawals from retirement accounts. The law was designed to help people affected by the pandemic, so you will need to demonstrate hardship. You can qualify if you, a spouse, or a dependent tested positive for COVID-19, was laid off as a result of the pandemic, or had work hours reduced. You may also qualify if you had to tend to children instead of working or if your business was forced to close.
Though you may qualify for the deal, that does not necessarily mean you should take advantage. Some people may have no other option, but the decision to cut into your retirement savings should not be taken lightly.
Taking money from a retirement account has significant downsides. Even if you plan to repay the money within three years to avoid taxes, you will miss out on the interest earnings from those investments. When you consider compounded effects, the difference could be quite significant. Therefore, you should only consider taking advantage of this new policy if absolutely necessary, and if so, only taking the minimum that you need to make ends meet.
Notably, people can take more than one distribution or loan in 2020, so it is better to err on the side of too little than too much. When you take out extra money, it is tempting to spend it rather than return it to the account.
How to Choose between Taking a 401(k) or a Retirement Distribution
Individuals who find themselves in need of financial relief have two distinct options under the CARES Act. The first is a 401(k) loan, which is the riskier of the two options. With this loan, you will be required to start making payments on the loan, with interest, immediately. If you default on this loan, you will be forced to claim the outstanding balance of the loan as a distribution in the year that you defaulted, which means paying taxes and the 10 percent penalty on that loan. If you lose the job through which you have the 401(k), you will need to repay the loan before the due date of the current year’s tax return. Otherwise, taxes and penalties will be due on the outstanding balance.
A distribution, on the other hand, helps you avoid much of this risk, especially since the limit on distributions and loans are now the same. The benefit of taking a distribution is that tax payments on the amount are stretched over three years, so the immediate financial impact is not as significant. Also, you retain the right to repay the distribution within three years if your financial situation suddenly changes. Doing this not only helps provide a boost to your retirement account, but it allows you to avoid paying taxes on the amount at all. While neither situation is ideal, a distribution is likely the safer option.