The coronavirus relief package that was signed into law last week included relaxed rules for taking money out of your retirement account. But while the option now exists for those who need the financial lifeline, there are several considerations to keep in mind before you start moving money around.
First, let’s look at the changes.
Early withdrawal rules for retirement accounts
You can take a distribution of up to $100,000 from your retirement account for “coronavirus-related” purposes. The usual 10% penalty is waived. You have until the end of the year to do this.
If you replace the money within three years, you don’t have to pay income tax on the amount. Otherwise, you have three years to pay the taxes on that money.
You can also choose to take a loan from your 401(k) (or 403(b) or other employer-sponsored account) for up to $100,000 instead of the usual $50,000. (You can’t take a loan from your IRA.)
This option is only available for 180 days after bill passed on March 27—so, the end of September.
Typically, you can’t withdraw more than half your balance, but that’s suspended during this period. If you have a loan out and it’s due back this year, you get an extra year to pay back the full amount.
Who’s eligible for a penalty-free early distribution?
The expanded early distribution rules apply to three categories of people:
- Those who were diagnosed with the coronavirus
- People who have a spouse or dependent diagnosed with coronavirus
- Anyone who faces financial hardship due to the coronavirus
That third group is where it gets tricky. Here’s what’s included in that “financial hardship” category:
- Being quarantined
- Being furloughed or laid off
- Having work hours reduced
- Being unable to work due to lack of child care
- Closure or reduction of hours for a business you own or operate
- “Other factors as determined by the Secretary of the Treasury”
“The interpretation is really loose,” said Whitney Morrison, a CFP and director of financial advisory at LegalZoom. “It’s available to most people.”
This is your last resort
Before you take a distribution or loan from your nest egg, make sure you exhaust your other options.
“$100,000 is a lot,” Morrison warned. She said that while small business owners with payroll to cover may need that much to float them over this uncertain period, it could be risky for an individual to access anywhere near that much. “You could potentially liquidate your entire 401(k),” she said.
“The market is down and it’s been really bumpy,” Morrison said. “Any distribution you take right now, even if you put money back in later, is locking in that loss.”
While taking a distribution or loan is a better option than high-interest debt like a payday loan, Morrison said it should only be considered if you don’t have income, savings, family who can help, or no interest/low-interest options like a credit card balance transfer offer.
Don’t forget about the other resources available right now, said Jorge Soriano, a CFP and financial advisor at GTE Financial in Tampa. From your relief check to expanded unemployment benefits to requesting accommodations for your mortgage or utilities, “Work out a way you can pay [your bills] before withdrawing any money from your plan,” he said.
If you must take this route, Morrison said not to get overzealous because you’re worried you won’t have enough cash to get by—or worse, because you’d rather have cash than wait out a rocky stock market. “Start with small amounts, and if you need more, take more out later,” she said. With loans available until September and distributions available until December, you can revisit your retirement funds if you need an emergency boost down the road.
A retirement distribution or loan doesn’t require a credit check, which can make it a more feasible option if your credit is poor. But even if you don’t have to pay penalties and you get extra time for taxes, “you’re still taking away from future you,” Morrison warned.
The younger you are, the riskier it is
If you’re in your 20s or 30s, you might think you have plenty of time to get back on track after taking money out of your nest egg. But Morrison warned that you could be a the greatest disadvantage. “Think about what makes retirement accounts so powerful: The long time to grow and build thanks to compound interest,” she said. If you take money from your retirement account at 55, you won’t lose too much growth potential, whereas someone who’s 35 will miss out on decades of growth potential.
“It hurts your retirement a lot when you withdraw when the markets have had such a huge pullback as we’ve seen in the last month,” Soriano said. “That return will be very difficult for you to get back to.”
Take a look at some quick math on this. Say you start saving for retirement at 25 by putting away $5,000 per year with a 5% return (we’re going super conservative here, humor me).
That’s a nice nearly $604,000. But say you started that account, then wiped it out back to $0 when you’re 29. The following year, you start saving again. You only lost five years of progress, right? True, but it’s more like five years plus the compounding interest of those five years and each year to come.
Yes, you got through some hard times, but you put your future self at a $153,000 disadvantage.
If you do choose to take a distribution now, “Consider withdrawing from the position that hasn’t taken a big fall,” Soriano said. That might be a cash-equivalent IRA or a money market account. The more conservative the investment, the better you can minimize the loss when you take out cash.
Prepare yourself for the eventual tax bill
Although you won’t have to pay an early distribution penalty on the money you withdraw, you’ll still need to pay income tax on that money.
Morrison said some firms will automatically withhold 20% of your funds to cover taxes before giving you the rest. If that’s not the case for your account, make sure to set aside at least 20% for your taxes.
If you know your tax rate, Soriano said it can be your guide to putting aside what you’ll owe on these funds. If your tax rate is 24% and you take a $100,000 distribution, you’ll owe $24,000 on that withdrawal.
“Hold it in a savings account and put it aside,” Morrison said. “If you have to eventually use that money down the road, you can potentially set up a payment plan with the IRS” for the taxes you owe.
Talk to someone before you do this
Although Morrison and Soriano agreed that taking a retirement distribution should be your last resort, they also stressed the importance of talking to someone first. “It always pays to have a second set of eyes,” Soriano said.
If you already work with a financial planner, don’t start filling out online forms late one night without telling them your plans. Take time to sit down and talk through all your optionsIf you don’t have an advisor, there are low-cost and pro-bono options available during the pandemic.