Your wisest, calmest friends may be fond of saying things like, "This too shall pass." And although there's truth in those words, that truth doesn't help you pay your bills after a sudden loss of income.
COVID-19 has already taken a toll on your retirement savings, and your paycheck could be next. The latest estimates on coronavirus-related job loss in the U.S. are mind-blowing. The Economic Policy Institute predicts more than 3 million jobs lost, and a Moody's Analytics report estimates that 10 million workers could see their income impacted by lower pay, furloughs, or layoffs. If you work in travel, hospitality, retail, dining, or entertainment, you may have already been affected.
In that case, a different adage might be more useful: "Desperate times call for desperate measures." When the bills are piling up and your emergency fund balance is dwindling, you can tap your retirement accounts to raise cash fast. Here are five options you could take -- but ones you'll probably regret later.
1. 401(k) loan
Most 401(k) plans allow for quick access to borrowed funds. You may be able to log in to your account online, request a loan, and have the money in your hands in a few days. That's a plus, especially if need to pay your rent next week.
Your plan will liquidate investments in your account to raise the cash you need. In the current environment, that liquidation likely results in a realized loss. That might be good or bad, depending on how you look at it. If the market continues to slide, at least the cash you borrowed won't be losing value. But if you take too long to repay those funds, you may miss some recovery gains.
The biggest risk you'll face is losing your job before you repay the loan. At that point, you'd have until the following tax day to settle the balance. Otherwise, the IRS will hit you with a 10% tax penalty on the outstanding amount.
You can borrow up to 50% of your 401(k) balance or $50,000, whichever is less. The interest rates are normally competitive, but also fairly immaterial since you pay the interest back into your account.
2. 401(k) early hardship withdrawal
If you've already borrowed the maximum from your 401(k), you could access more cash by taking a hardship withdrawal. This is a radical move, though. First, you're spending your retirement savings well before retirement. You'll also pay income tax plus a 10% penalty on the distribution. And, you'll have to prove to your plan administrator that you are, indeed, facing a hardship.
Each plan defines what constitutes a hardship, but the IRS allows for these circumstances:
- Medical costs.
- Costs related to the purchase of a primary home.
- Tuition expenses.
- Cash needed to keep you from being evicted or to prevent a foreclosure on your primary home.
- Burial or funeral expenses.
- Cost of repairing your primary home.
Per IRS rules, the amount of the withdrawal cannot exceed what's necessary to address the hardship. Also, you can only withdraw contributions made by you or your employer. You cannot withdraw any earnings. And once you take the money out, you have to wait six months before you make additional contributions to your account.
3. 401(k) cash out
A job loss gives you another way to access those 401(k) funds -- you can cash them out entirely. Your plan administrator may withhold 20% to cover some of your tax liability. That tax liability will include income tax and, if you are under 56 years old, a 10% penalty. The IRS applies your overall income tax rate in the calculation. That tax rate will be based on your total income, which now includes the 401(k) withdrawal. If the withdrawal is large, it could bump you into a higher tax bracket.
You do have 60 days to avoid the penalty by depositing the funds in another plan or an IRA. If you can resolve your situation quickly, you could treat this cash-out as a free, short-term loan.
4. Life insurance loan
Like a 401(k) loan, a life insurance loan puts money in your hands fast, usually within 10 days. You can only borrow from a life insurance policy that has accumulated cash value. Your policy will define the terms of the loan, but they're usually competitive. Expect a low interest rate and no repayment requirements. Your cash may even stay invested and earning for you. That's because you're not actually borrowing your own cash; instead, your insurer uses the cash value as collateral for the loan.
You do have to keep paying your premiums, though. Life insurance loans are not normally taxable, but they could become taxable if you let the policy lapse.
5. Roth IRA distribution
You can withdraw your Roth IRA contributions -- but not the earnings -- at any time without penalty. The IRS assumes any withdrawals you take are contributions first, and earnings second. That means you won't pay a penalty unless you take out more than you've put in.
Because there's no interest, no repayment requirement, and no tax implications, a Roth IRA distribution is the least painful way to cash out your retirement savings. The biggest downside is the impact on your savings timeline. Your balance goes down immediately and takes your future earnings potential down with it. That is less of an issue today, given the state of the market, but it will be an issue in the future.
Tapping retirement is temporary
Tapping your retirement savings can keep you afloat during tough times, but it is a temporary solution. It's obvious, but worth stating, that what you borrow or withdraw today won't be available tomorrow. As soon as your situation stabilizes, repay funds borrowed and increase your retirement contributions. The faster you put the money back, the better. As your wise friends might remind you, "A penny saved is a penny earned."