The coronavirus pandemic has had a huge impact on people's lives, and the effects are going well beyond health. Millions of people have lost their jobs, at least temporarily, and there's huge uncertainty about when many will be able to go back to work.
Given how desperate the financial situation is, many people are looking at taking drastic measures to stay afloat. It's therefore understandable that lawmakers in Congress decided that they wanted to give people some access to the money that they'd set aside in tax-favored retirement accounts like IRAs and 401(k)s.
That's usually a terrible idea, but the provisions of the coronavirus bill that allow people to tap into those accounts without paying the usual 10% penalty could avoid the typically devastating repercussions of using retirement savings early. All you have to do is commit to the unique provision that allows you to pay yourself back.
What the coronavirus stimulus bill did
The $2 trillion coronavirus stimulus bill sought to support Americans financially on a number of fronts. The part of the legislation that's gotten the most attention involves sending checks for $1,200 per adult and $500 per child to the majority of the American public in an effort to help them shore up their near-term finances and provide an emergency cushion for those who've lost their work income as a result of the pandemic.
For those who are truly struggling, though, $1,200 won't necessarily go all that far. Lawmakers therefore added some other provisions that would allow people to get access to financial reserves that they'd otherwise be less likely to tap.
One of those provisions allows people to withdraw up to $100,000 from retirement accounts like IRAs and 401(k)s in hardship distributions. These withdrawals would be exempt from the usual 10% penalty that applies to money taken out of retirement accounts before you turn 59 1/2 years old.
Why taking money early from your retirement savings is usually a bad idea
Many people already raid their retirement savings early. Some choose just to take cash from their 401(k) plans when they switch jobs rather than rolling the money over into a new 401(k) or IRA. Others treat retirement accounts the same way they would a savings account.
The regular rules for such withdrawals try to discourage people from taking their money out of traditional IRAs and 401(k)s. A 10% penalty usually applies, and you almost always have to include the amount withdrawn in your taxable income for the year you take it out. That means for every dollar you take out, you could end up paying anywhere from $0.20 to $0.47 in taxes and penalties.
The longer-term consequences are even bigger. By taking that money out now, you'll miss out on years or even decades of growth. Taking out $10,000 now could slash $100,000 or more off the size of your eventual nest egg down the road.
The ingenious way lawmakers are allowing temporary relief
However, the coronavirus stimulus bill includes an extra provision that makes the prospect of tapping retirement savings more acceptable. Anyone who takes a distribution can contribute the money that they took out back to a qualifying retirement plan account. If they do so, they'll be treated as if they'd met the rules that allow you to roll over retirement money from one account to another.
What that means is that as long as you get the money back into a retirement account within three years, there won't be any tax consequences. You won't pay the penalty, and you won't have to include the distribution you received as taxable income.
Even so, you'll still lose the investment gains you would've earned if you'd left the money alone, so it's not a perfect solution. Nevertheless, the unique provisions of the coronavirus stimulus bill make taking early retirement withdrawals a lot more palatable.
Commit to paying yourself back
If you're going to use this relief provision, it's essential to commit to getting that money back into a retirement account within the three-year period. Only by doing so will you avoid the problems involved in tapping your retirement early -- and keep your retirement planning on track toward a prosperous financial future.