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401(k) Withdrawal: Why It's in the News

By Kailey Hagen – May 7, 2020 at 10:20AM

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It's not just relevant to retirees.

If you've been skimming the news headlines since the COVID-19 pandemic began, you've probably run across at least a couple of articles about 401(k) withdrawals. You may not think they're relevant to you if you're nowhere near retirement age, but 401(k) withdrawals should be on everyone's radar right now as our nation struggles to get the economy back on its feet again.

The CARES Act has temporarily changed some of the rules surrounding 401(k) withdrawals to assist those who are struggling financially due to the pandemic. It's good news for those who aren't sure how they're going to cover next month's bills, but there are long-term consequences to making an early 401(k) withdrawal that you have to weigh as well. Here's everything you need to know about 401(k) withdrawals during the pandemic to help you decide.

Mature couple doing financial calculations

Image source: Getty Images.

The new rules surrounding 401(k) withdrawals

In pre-pandemic times, you could withdraw money from your 401(k) at any time, but you'd pay income tax on the money you took out, unless you took a 401(k) loan or withdrew money from a Roth 401(k). You'd also pay a 10% early withdrawal penalty if you were under 59 1/2 years of age, unless you met certain exceptions like a first home purchase or a large medical expense. Adults 72 and older were actually mandated to withdraw money, known as required minimum distributions (RMDs), from their 401(k)s every year so the government could get its cut of their savings.

The CARES Act has changed some of the rules. First, you can make penalty-free withdrawals under 59 1/2 of up to $100,000 per year if you meet one of the following criteria:

  1. You have been diagnosed with COVID-19.
  2. Your spouse or dependent has been diagnosed with COVID-19.
  3. You have suffered adverse financial consequences due to COVID-19.

The last one is a little vague, but it includes individuals who have been laid off, furloughed, or had their hours cut during the pandemic. It also includes individuals who cannot work because they must stay home to care for children who cannot attend school and business owners who aren't able to work because of the pandemic.

You still owe taxes on your distributions, but if you withdraw money now, you can spread that tax liability out over three years instead of having to pay for it all on your 2020 taxes. Or if you're able to put the money you borrowed back into your 401(k) within three years, you can claim a refund for the taxes you've paid, so it's almost like you didn't withdraw any money at all.

401(k) loans are still an option if your company allows them, but you can now borrow 100% of your vested balance up to $100,000 -- double the normal limit. You can also delay payments on these loans for up to a year. Check with your plan administrator to learn more about the repayment terms.

Retirees living off of their savings, including the money in their 401(k)s, will be pleased to know they don't have to take a RMD this year. You're still free to withdraw money from your 401(k) if you want to or need to to cover your living expenses, but you can also leave the money untouched in your account if you'd like, so you don't have to sell off your investments at an inopportune time to appease the government.

Think carefully before you withdraw money from your 401(k)

The CARES Act has removed a lot of the obvious penalties that were in place to dissuade people from withdrawing money from their 401(k) before retirement age, but that doesn't mean withdrawing money now is penalty-free.

When you take money from your 401(k), you're taking money away from your retirement. Every day the money remains invested in your account, it fluctuates in price and over time, it typically rises. The money you contribute while you're young usually means more than money you contribute when you're older because your earlier investments have more time to appreciate before you need to withdraw them. By taking funds out now, you're setting yourself back, and you'll have to contribute more in the future to have enough for retirement.

Withdrawing money now may also mean selling at a bad time as a lot of investments have plummeted during the pandemic. Many will likely recover, but for now, withdrawing $1,000 from your 401(k) could require selling off a lot more of your investments than it would have at the beginning of the year. That'll set your retirement savings back even further.

Taking out a 401(k) loan or paying back your withdrawal within the three-year time frame can ease some of the negative effects on your retirement savings, but if you're not able to pay back what you borrowed within the allotted time frame, you'll have a larger tax bill on top of less retirement savings.

Times are tough for a lot of Americans right now, so I'm not trying to dissuade you from using your retirement savings if you really need them to make ends meet. But just think it over carefully, make sure you understand the consequences, and exhaust all of your other options first. If you have an emergency fund, use that before tapping your retirement savings. You could also explore other options, like coronavirus hardship assistance programs. You may realize there are other ways you can make ends meet without dipping into your 401(k).

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