Typically, the penalty for withdrawing from a 401K before the age of 59½ is 10% of the distribution, plus an automatic withholding of at least 20% for taxes. But with the passage of the CARES Act, that all changes for 2020.
The $300 billion earmarked for direct payments is getting considerable attention, but the CARES Act’s language on early withdrawals from retirement accounts is remarkable in itself. Here’s a broad overview:
Individuals affected by COVID-19 can withdraw up to $100,000 from employee-sponsored retirement accounts like 401Ks and 403(b)s, as well as personal retirement accounts, such as traditional individual retirement accounts, or a combination of these.
- The 10% penalty will be waived for distributions made in 2020.
- There are no mandatory withholding requirements.
- The distribution can be taxed as income spread evenly over tax years 2020, 2021 and 2022. However, if you can pay back the amount you took out within three years, you can claim a refund on those taxes.
- 401K plan participants can now take out 100% of their vested balance (previous rules limited borrowers to 50%) as a loan up to $100,000, and payments on this loan can be delayed for up to one year.
The CARES Act also waives required minimum distributions from retirement accounts in 2020 — a significant update for today’s retirees.
Those aged 70½ and older can forgo the distribution and let it grow for another year, which can help prevent retirees from having to sell stock investments at a bad time. This can also allow retirees to reduce their income taxes in 2020 without the distribution.
Who is eligible for coronavirus-related distributions?
If you, your spouse or a dependent have been diagnosed with COVID-19, you qualify for the above benefits. However, eligibility for coronavirus-related distributions extends well beyond those who have been diagnosed, including:
- Any individual who has experienced “adverse financial consequences” because they’ve been quarantined or furloughed, or because their hours at work were cut.
- Individuals who haven’t been able to work because they’ve had to stay home to take care of their kids.
- Business owners who have had to slash operating hours or shut down due to the outbreak.
If I’m eligible, should I take a distribution from my 401K or IRA?
Even with the new rules in place, it’s still advisable to exhaust most other resources, such as emergency funds or other easily accessible forms of savings, before tapping into your retirement accounts.
But if you are considering taking a distribution from your IRA or 401K, think through the following first.
You may be hurting your retirement
Every dollar you take from your 401K or IRA today means less you’ll have in retirement — much less, thanks to compounding interest.
Let’s say you have $50,000 in your 401K, and you take a $5,000 penalty-free distribution. If you don’t pay it back, not only will you forgo the tax refund, you’ll miss out on substantial long-term growth.
In this scenario, $50,000 could grow to about $160,400 after 20 years without any additional contributions. Conversely, $45,000 might only grow to about $144,300. So the $5,000 paid the bills in the short term, but cost you about $16,000 in the long term.
You may have to sell investments at a bad time
Pulling cash out of investment accounts after the market has fallen means you’re locking in any losses you’ve incurred. Even if you reinvest these funds down the road, you’ll have missed reaping any gains those investments would have seen in the interim.
In 2020, the S&P 500 had its largest first-quarter decline in history, finishing down 20%. Stats like this can lead to panic selling, or, coupled with the loosened withdrawal rules, may tempt you to dip into retirement accounts to prevent further losses.
You’ll still need to be mindful of taxes
You’ll still owe income tax on your distribution from any tax-deferred retirement account. However, if you pay the distribution back within three years, you can file for a refund of the taxes you paid on that distribution.
Also worth noting: The income can be claimed all at once in 2020 for tax purposes, or spread evenly over the next three years. In many cases, dividing it evenly over three years may result in a better tax situation, as it’s less likely to bump you into a higher tax bracket in any single year.
If your income is expected to be lower in 2020 than the subsequent two years, though, it could make sense to claim all of the income on your 2020 tax return. Not only might this minimize the effective tax rate you pay on this income, but you’ll also have two years to pay back the distribution and ultimately get a refund.
Keep in mind that if you have a Roth IRA, it may still be a better choice for withdrawals than your 401K or IRA. That’s because savers can always withdraw contributions (but not earnings) from their Roth IRA penalty- and tax-free.