Posted: June 1, 2020

Should You Cash Out a 401(k) Just Because COVID Says You Can?

Blue Rock RiversEdge

Amongst other retirement planning provisions, the CARES Act is temporarily allowing individuals impacted by the Coronavirus to access up to $100,000 from their 401(k)s and IRAs without the usual consequences. But, is it worth it? What are the long and short-term consequences of taking invested money out of your 401(k) early?

What has changed?

Typically, money withdrawn before age 59 ½ from your 401(k) would be subject to a 10% penalty fee as well as an automatic withholding of at least 20% of your withdrawal for taxes. Under the CARES Act, though, individuals affected by the COVID-19 pandemic are able to withdraw up to $100,000 from employee-sponsored retirement accounts like 401(k)s, 403(b)s, personal retirement accounts, traditional individual retirement accounts, or a combination of these without incurring the 10% penalty if the distribution is made in 2020. The mandatory tax withholding requirements have also been dropped for these qualifying distributions.

 What’s the tax?

Because funds in these types of accounts are made with money that has not yet been taxed, they are subject to income tax (just like they would be in retirement).  However, taxes on a qualifying COVID-19 related distribution can be spread evenly over the next three years—2020, 2021, and 2022—to help ease the burden. If you pay back the withdrawn amount within three years, though, you can claim a refund on those taxes.

What’s the catch?

Is it worth it to withdraw from your 401(k) or other similar retirement accounts simply because a few penalties have been temporarily bent to make the funds more accessible? The long and short of it is that it depends.

In general, pulling money out of the market isn’t advisable. But for those who have exhausted all other options and feel the ends justify the means—that is, their financial strain is so great that the downsides are preferable—then it could be a good option.

Before making a decision, consider the following:

1) You could incur notable loss on your investments: Pulling money out of a down market locks in the losses your money has incurred since the downturn. Even if you decide to reinvest at a later date, you may miss the gains of a rebound in the interim. Keep in mind, though, losses aren’t actually realized until an investment is sold. So, if you can “weather the storm” and leave your money invested in a volatile market, you will actually not have suffered a loss, but a gain.

2) You could severely injure your retirement: For every dollar you take out of your investment account now, you are taking thousands (or hundreds of thousands) of dollars away from yourself in retirement thanks to the compound interest that dollar would have earned over time. Let’s say you take $100,000 out of your 401(k) today to meet your short-term needs, leaving your current account balance at $350,000 rather than $450,000. After about twenty years, without any additional contributions at an average rate of return of 8%, your $450,000 could have grown to about $2,097,431 whereas $350,000 would only have grown to about $1,631,335.That means your short-term needs didn’t actually cost you $100,000 (plus the taxes incurred if you didn’t pay it back), but $466,096 in the long-run.

3) You could push yourself into the next tax bracket: Don’t expect to receive income without having to pay taxes on in some form or another. Yes, if you take your 2020 COVID-19 distribution and decide not to repay the account, you can spread the tax liability over the next three years. However, this could push you into a higher tax bracket, increasing the total percentage taxed on all income. If you are on the top end of a bracket, you will want to carefully decide how to avoid this jump up. Or, if your income is expected to be lower in 2020 than in the next two years, you could choose to pay taxes on the entire amount now and avoid a bracket push in the future.

If you really need the funds, consider a loan.

If you are confident you’ll be staying with your current employer for the next five years or more, you may want to consider taking out a COVID-19 eligible loan against your 401(k) instead. Here’s why:

  • You can access your funds now and repay the loan without incurring the 10% early withdrawal penalty.
  • You won’t have to pay tax on the distribution as long as the funds are repaid within the specified time frame, which is typically about 5 years.
  • All loan payments due in 2020 can be delayed for up to one year from the date you took the loan.

However, keep in mind that if you leave your job and fail to pay your loan back within the specified time frame, you will incur the 10% penalty as well as be charged income tax on your distribution.

Seeking Sound Advice

Still unsure if using funds from your 401(k) would be the best way to ease your current financial strain?

At Blue Rock RiversEdge, we understand that the COVID-19 pandemic has changed many Americans’ financial realities in an unsettling way. For some, accessing 401(k) funds is the best option, while others may be able to seek alternative routes.

Contact us today to learn more about how our advisors could help you decide which option is best for you.

Comments are closed here.