The COVID-19 crisis is wreaking financial havoc on millions of Americans, and so in late March, President Trump implemented the CARES (Coronavirus Aid, Relief, and Economic Security) Act to provide economic relief. Included in that package is a one-time $1,200 stimulus payment for qualifying adults, extra unemployment benefits, and a set of more relaxed rules for retirement savings plans like IRAs and 401(k)s.
With regard to the latter, plan holders affected by COVID-19 can now withdrawal up to $100,000 from an IRA or 401(k) before age 59 1/2 without incurring the 10% early withdrawal penalty that would normally apply. Required minimum distributions, meanwhile, can be delayed an extra year (normally, they kick in at age 72). And those who choose to borrow from a 401(k) now have the option to take out a larger loan. But borrowing from a retirement plan is a dangerous move to begin with, and borrowing at an even higher rate could spell serious trouble for your retirement.
New 401(k) borrowing rules
Before the CARES Act, 401(k) loan limits were capped at $50,000 or 50% of your vested account balance. But thanks to the new relief package, you can now borrow up to $100,000 from a 401(k), or up to 100% of your vested account balance if it's less than $100,000. IRAs, meanwhile, have never provided a loan option -- and the new rules still won't let you borrow from one.
If you're feeling cash-strapped, you may be inclined to take out a larger 401(k) loan in the coming weeks. But before you do, consider the pitfalls involved.
The dangers of borrowing from a 401(k)
Perhaps the greatest danger of a 401(k) loan is that you might struggle to pay it back. And that's troubling for a couple of reasons. First, if you don't pay back your loan, you'll be hit with a 10% early withdrawal penalty on the amount you fail to put back into your account.
Now you may be thinking: "Doesn't the CARES Act allow for a $100,000 retirement plan withdrawal without penalty?" And you'd be correct, except for the fact that a defaulted loan is not considered a penalty-free withdrawal, nor is it converted to one if you're unable to pay.
Furthermore, if you don't repay your 401(k) loan, you'll risk falling short financially during retirement. Additionally, you'll generally lose out on an employer match for your 401(k) during your loan's repayment period. And that also increases your risk of not having enough money at your disposal once you leave the workforce.
Be careful with 401(k) loans
If you really need to take out a 401(k) loan, make sure to borrow as little as possible. You may be allowed to borrow up to $100,000 right now, but if you only need $15,000 to keep up with near-term expenses, don't take out more than that.
It also pays to explore other affordable borrowing options before taking a loan from your 401(k). If you own a home, for example, a home equity loan or line of credit may be a more suitable alternative.
Finally, to qualify to borrow extra money from your 401(k), you'll need to have been negatively impacted by COVID-19 -- whether that means falling ill, being forced into quarantine, or seeing a reduction in your working hours. Unfortunately, a wide range of people have been hurt by the crisis already, so the option to take out a larger 401(k) loan will be on the table for many. But proceed with caution if you're going to go that route so you don't regret the decision after the fact.