Cashing Out a 401(k) Due To COVID-19: What You Need To Know

©Shutterstock.com

Even before COVID-19, people turned to retirement plans as a funding source for paying off medical bills, settling a bankruptcy or getting out of debt. For many, it was a last resort due to having to meet specific requirements, pay an early withdrawal penalty of 10% and navigate their retirement plan’s complex withdrawal rules.

The Coronavirus Aid, Relief and Economic Security Act, which was signed into law earlier this year, eased some of these restrictions. One section of the law relaxes existing 401(k) withdrawal rules to provide additional support for Americans who have been affected by the virus. If you’re considering cashing out a 401(k) during COVID-19, learn more about the law and how it affects you.

Cashing Out a 401(k) During COVID-19 Through the CARES Act

The CARES Act was signed into law in March in response to the effects of the COVID-19 pandemic. One section of the law details COVID-19 401(k) withdrawal guidelines and rollover options to support Americans who have been affected by the virus.

Anyone with a 401(k), 403(b) or a personal retirement account should be aware of these key provisions that make it easier to access retirement funds during this time of need:

• You can withdraw up to $100,000 from eligible retirement plans.
• Previously, anyone under the age of 59 1/2 would pay a 10% penalty for early withdrawal, but this has been suspended.
• There are no minimum distribution requirements or mandatory withholding requirements.
• Although withdrawals count as taxable income, you can distribute the tax liability over the next three years: 2020, 2021 and 2022.

These withdrawal rules also apply to individuals with an individual retirement account as long as they meet the COVID-19 withdrawal requirements.

Eligibility and 401(k) COVID-19 Withdrawal Qualifications

The CARES Act uses the following criteria to identify qualifying individuals:

Criteria for Qualifying Individuals

• Anyone diagnosed with SARS-CoV-2 or COVID-19 by a test approved by the Centers for Disease Control and Prevention
• Anyone whose spouse or dependent is diagnosed with SARS-CoV-2 or COVID-19 by an approved test
• Anyone facing adverse financial consequences after being furloughed, laid off, quarantined or having reduced work hours because of SARS-CoV-2 or COVID-19
• Anyone unable to work because of lack of child care related to SARS-CoV-2 or COVID-19
• Anyone who had to close a business or reduce business hours because of SARS-CoV-2 or COVID-19

Employer Participation

CARES Act rules do not mandate companies to modify their retirement plan rules. For example, employers may opt to provide for coronavirus-related distributions but choose not to change plan loan provisions or loan repayment schedules, according to the IRS.

Advice

If you’re considering taking money out of your account, find out your plan’s 401(k) coronavirus distribution requirements. It’s also helpful to understand the difference between a withdrawal and a loan as well as other plan-related terms.

Pros and Cons of Taking Money Out of a 401(k) During COVID-19

Using your 401(k) during COVID-19 can be helpful if you’re struggling financially. However, it may not be the best option and can have significant consequences for your retirement plans.

Pros and Cons of Withdrawals

When you withdraw money from your retirement account — instead of taking a loan — you don’t have to worry about paying it back. If your employment situation is unstable and you don’t know when your income will return to its pre-COVID-19 level, not having extra payments can be a relief. Here are some other pros — and cons — to consider:

Pros

• You can spread out the withdrawal over the next three years to lessen the tax burden.
• You have the option of paying back the withdrawal to avoid income taxes.

Cons

• You will miss out on the amount you removed from the account and all the interest that money would have earned over the next few years.
• Your retirement account may not return to pre-COVID-19 levels. The closer you are to retirement, the less time you have to rebuild your savings.
• The money you withdraw is considered taxable income, and you will have to pay your ordinary income tax rate on it unless you choose to pay back the withdrawal.

Pros and Cons of Loans

A loan can be a better option for some people who want to protect their retirement savings. Take the following pros and cons into consideration:

Pros

• You pay back what you borrow, plus interest, which means you won’t permanently deplete your account.
• Under the CARES Act, you have up to five years to repay the loan.

Cons

• Some plans require immediate repayment of the loan if you leave the company.
• If you cannot repay the loan, you’ll be in default and subject to taxes and additional penalties.
• You’ll lose out on investing the money you take out in a loan, and the missed investment growth could equal more than the interest you repay to your account.

What To Consider When Cashing Out Your 401(k)

If you’re strapped for cash, having access to the money in your 401(k) is tempting. But taking money out of your 401(k) during COVID-19 can affect your retirement. The money you take out may be gone forever unless you can replace it before you retire.

You’ll also miss out on the interest that balance could have earned over the next few years. According to the Consumer Financial Protection Bureau, the $100,000 you withdraw today could be worth more than $160,000 if you left it in the account for 10 years with a 5% growth rate.

If you do decide to cash out your 401(k) due to COVID-19, keep in mind the following:

What To Keep in Mind

• Keep records of the withdrawal and how you spend the money.
• File your taxes. You do not have to pay the additional 10% tax penalty for early withdrawals from a retirement account, but you do have to pay income tax on the money.
• Be wary of individuals who encourage you to take advantage of the CARES Acts provisions and promise to help you invest your money in more profitable products.
• Seek 401(k) COVID-19 advice from licensed investment professionals and verify their licenses.
• Remember that the purpose of the CARES Act is to help people facing hardships and not for investment opportunities.

Alternatives to a 401(k) Withdrawal and 401(k) COVID-19 Advice

If your plan doesn’t allow withdrawals, or you want to avoid taking money out of your retirement accounts, there are alternatives to tapping your 401(k). Here are some to consider:

• Emergency fund: Ideally, you should have enough money set aside in an emergency fund to cover at least three to six months of expenses.
• Savings: If you have access to other forms of savings, such as a vacation fund, consider using money from those sources that will be easier to replace when your financial situation improves.
• Credit cards: You may turn to credit cards to cover expenses, but don’t plan to rely on them for an extended period. Carrying a high balance can result in costly interest charges and can lead to other long-term financial challenges.

Financial help may also be available through other sources near you. Here’s a look at a few options.

Banks

Your bank or credit union may be able to help you manage your bills if you’re unable to pay them because of COVID-19. Possible options include deferring payments on credit cards and loans, waiving late fees and offering short-term emergency loans. Call your bank to learn more about these services and how to qualify for them.

Community Programs

State and local programs are offering help for community members. They have provided food, supplies and support grants for people in need. Contact your local United Way, community foundation or church to find out what’s available in your area.

Credit Counseling Agencies

Credit counseling agencies can help you get control of your finances. They may show you tips on how to create a budget or handle debt collectors. You can find free services through your bank or credit union, local consumer protection agency, church or community foundation.

Websites

You can also find free or cheap financial advice online. Some sites provide resources. Others connect you with professionals who can assist you for free or a reduced fee. Here are some to consider:

• LawHelp.org: Information about legal tools and referrals to attorneys
• Federal Trade Commission: Advice for dealing with debt
• USA.gov: Information on food and housing assistance

Laira Martin contributed to the reporting for this article.

This article has been updated with additional reporting since its original publication.

Share this article: