The coronavirus pandemic has turned the world upside down, wreaking havoc on people's health, the world economy, and job security.
Approximately 22 million Americans have filed for unemployment benefits over the last month, and with no end in sight for the pandemic, that number could continue to rise. Because jobs are so scarce right now, many of those who are currently unemployed might stay unemployed for the foreseeable future until the stay-at-home orders lift and the economy begins to recover.
If you've lost your source of income and need help making ends meet, you might be tempted to tap your 401(k) or IRA. However, there are a few drawbacks to that approach that you should consider carefully.
Image source: Getty Images.
1. You'll still need to pay taxes on your withdrawals
Under the new Coronavirus Aid, Relief, and Economic Security (CARES) Act, the early distribution penalty is waived for retirement account withdrawals. Typically, you can expect to pay a 10% penalty and income taxes on the amount you withdraw from your 401(k) or IRA before age 59-1/2. But for now, that 10% penalty is waived if you need to make withdrawals to pay for coronavirus-related expenses.
However, you'll still need to pay income taxes on the amount you take from your retirement account. The bright side is that you now have three years to pay those taxes, but if you withdraw a significant amount of money, that could be a hefty tax bill -- even over three years.
2. You'll be locking in your losses
It's never necessarily a good thing to withdraw from your retirement fund before you reach retirement age, but it's especially detrimental during a market downturn.
As more Americans lose their jobs, there's a good chance we could be headed toward a full-blown recession. During a recession, stock prices are at their lowest. That doesn't necessarily mean you've lost any money yet, though, because no matter how far the market falls, you can't actually lose any money until you sell your investments.
So it's best to keep your money invested and weather the storm if at all possible, because if you withdraw now, you'll essentially be locking in your losses. If you've been investing for years back when the market was stronger, you're essentially buying high and then selling low if you withdraw your money when stock prices are at rock bottom.
3. It will be harder to catch up on your retirement savings later
Retirement may be the last thing on your mind right now, but it creeps up quickly -- even if you're relatively young. Saving for retirement takes decades, and withdrawing even a little bit of cash now could make it harder to reach your goals in the future. Compound interest allows your investments to grow faster the longer they sit untouched in your retirement account, so by withdrawing some of your savings now, you're missing out on all the potential gains you could have earned by leaving that money alone.
If you have decades until you plan to retire, withdrawing some of your savings now won't be quite as harmful compared to if you expect to retire within the next couple of years. The more time you have to save, the easier it will be to catch up on your savings. But no matter your age, keeping your money in your retirement fund for as long as possible will help it reach its full potential.
What to do instead of tapping your retirement savings
If you've lost your income source and need help paying the bills, you may think that dipping into your retirement savings is your only option. However, there are a few other things you can try first.
Ideally, you should pull your money from an emergency fund rather than your retirement fund. If your emergency savings are stashed in a high-yield savings account, you can withdraw your money penalty-free and avoid touching your retirement account.
If you don't have an emergency fund or if you've already spent that money, you may consider taking a 401(k) loan. You'll still be taking money from your retirement fund, which isn't ideal, but you'll be required to pay the money back -- which helps keep your long-term savings on track. You also don't need to pay income taxes on your loan because it's not a withdrawal, and all the interest you pay will go back to your account. Under the CARES Act, you can borrow 100% of your vested 401(k) balance up to $100,000. In addition, while most 401(k) loans must be paid back within five years, the CARES Act gives borrowers an additional year to repay the loan.
Another option is to consider taking on credit card debt. It's typically best to avoid high-interest debt like credit card debt, because it's easy to rack up sky-high interest charges. However, if you just need a little money to get by and expect to be able to pay this debt off relatively quickly, this might be a smart option.
Times are tough right now for millions of families, and it can be tempting to pull cash from your retirement fund to make ends meet. By doing your best to find the money elsewhere, though, you can get through these difficult times while still keeping your retirement savings on track.
