Dismantling 401(k) has Significant Retirement Implications

The $2 trillion CARES Act contains widespread provisions aimed at dampening the economic hardships caused by the coronavirus pandemic. Under the CARES Act, qualifying individuals may tap into their retirement accounts without the typical penalties, including 401(k) and 403(b) plans.

Even though retirement plan funds may have become easily accessible overnight, dismantling even a portion of your 401(k) can have significant implications for retirement savings. It goes without saying that other emergency, non-retirement sources should be exhausted whenever possible. However, for those who are still considering drawing on their 401(k), it is important to know whether a withdrawal or a loan is best suited for your situation and the differences of each.

Eligibility

To take advantage of the eased restrictions on 401(k) access, you must first qualify. This includes business owners who have had to close or limit operations due to the outbreak or parents who have had to stay home to take care of children. This also extends to any individual who is experiencing financial hardship due to quarantine, reduced hours at work, or as a result of being furloughed. If either you, your spouse, or a dependent have been confirmed diagnosed with COVID-19, you are also eligible for these amended benefits.

401(k) Withdrawal

In the most simplistic sense, a 401(k) withdrawal functions as a source of income. This is money that you do not have to pay back and will be taxed just like any other source of income. The CARES Act has increased the maximum amount that may be withdrawn up to $100,000 per person. These withdrawals can be made from 401(k)s, traditional IRAs, or a combination of both.

For those individuals who will be taking a withdrawal from their retirement plans this year, the CARES Act has flexible provisions in place to lessen the tax burden. The income tax from the withdrawal can be claimed all at once in 2020, or individuals may opt to spread the taxes owed evenly over the next three years. Furthermore, if the withdrawal amount is fully redeposited within three years, you can claim a refund and recover the federal and state taxes paid.

For some households, claiming the entire withdrawal in 2020 would be advisable if your income is expected to be much lower this year, as this would also translate to a lower tax rate. For others, spreading the taxes over the longer time frame may help avoid graduating into a higher tax bracket.

Traditionally, individuals who were under the age of 59 1⁄2 and took a 401(k) withdrawal are subject to a 10% penalty and a mandatory 20% tax withholding requirement. Beginning January 1st, 2020, this penalty and the required withholding rate has been waived.

401(k) Loans

In contrast to a withdrawal, 401(k) loans are borrowed money that must be repaid within a certain timeframe to avoid penalties and taxes. Interest accrues for the duration of the loan and if it is not paid back within the given timeframe, the outstanding amount is taxed as income and a 10% penalty applies. It is important to note that job loss, voluntary or otherwise, will drastically shorten the amount of turn-around time to repay a retirement plan loan. Employees that leave their jobs have until October 15th of the following year to pay back their loan, or it will become a taxable distribution.

The CARES Act has revised the rules for retirement plan loans that are taken out between March 27, 2020, and September 23, 2020. The loan limit has been increased from $50,000 to $100,000. All loan payments that were due in 2020 can be deferred for one year, although interest will continue to accumulate. The guidelines surrounding 401(k) loans and changes in employment status are unaltered under the CARES Act.

Considerations

While the impacts of the pandemic may have redirected our focus to the here and now, it is imperative to not lose sight of the future and the inevitable recovery that will soon follow. Compounding interest means that even smaller distributions from retirement funds can translate to substantial losses in potential earnings.

Even if you are confident that you can redeposit any funds you may have borrowed or withdrawn at a later date, keep in mind that removing funds from your investments while the stock market is low means that you are solidifying any losses. If an emergency withdrawal is necessary, take out the minimum amount, which will help to preserve the majority of your assets for the impending upswing in the markets.

Lastly, the amendments from the CARES Act do not automatically apply to all 401(k) and other employer-sponsored retirement plans. Implementing these provisions is at the discretion of the employer and some may adopt only select aspects of the CARES Act. If you need to explore options regarding your 401(k) or other employer-sponsored accounts, be sure to discuss these directly with your company.

Planning for retirement has always been a matter of strategizing based on individual scenarios. The COVID-19 pandemic has introduced unforeseen circumstances and drastically changed much of our world. Yet individuals still need to respond with evolving strategies that accommodate their lifestyle, their resources, and their priorities. At least, in that sense, nothing has changed and working with a qualified financial professional can help ensure you make decisions that best fit your personal financial situation.