Over the past few months, a lot of people's financial goals have shifted. Rather than thinking about their futures, many are worried about how they're going to make ends meet each month. And rather than filling up their 401(k)s, some are tapping them to help them pay their bills right now.
The federal government has removed the penalty on early 401(k) withdrawals for individuals under the age of 59 1/2 due to the COVID-19 pandemic, but there are long-term consequences you have to weigh as well. Early withdrawals can make it more challenging to save enough for retirement. That could be the lesser of two evils right now, but you should still take steps to keep your retirement on track. Do these three things if you've taken or are thinking about taking a 401(k) withdrawal this year.
1. Prepare for taxes on your withdrawal
You won't pay an early withdrawal penalty on 401(k) withdrawals this year. But you will still owe taxes on these distributions, unless they come from a Roth 401(k). Usually, you must pay taxes on your distributions in a single year, and that's still an option now. But the federal government is granting people up to three years to pay taxes on their COVID-19 withdrawals.
Spreading out your tax liability can help you prevent ending up in a higher tax bracket this year than you're used to and owing a larger percentage of your income to the government. But if you're not earning as much as usual this year, paying the tax liability all in one year could be more beneficial than waiting to pay for some of it in 2021 and 2022 when your income will hopefully be back to normal.
The right move depends on how much you've withdrawn and how much other taxable income you earn during the year. Keep an eye on this as the year continues and decide which is the smarter option for you. If you're concerned about owing money to the government, you should keep some extra cash in savings to cover this.
2. Decide if you're going to pay back the funds
You must also decide whether you're going to try to put back the money you've borrowed as soon as you're able to. Doing so will minimize the damage the early withdrawal does to your retirement security, but it might not be feasible for everyone.
If you are planning to pay back the money, you have two choices. You can take a 401(k) loan if your plan allows it. These require you to pay back what you borrowed plus interest, which goes toward your retirement. You usually have five years to pay back what you borrowed, but sometimes the timeline is longer. If you can't return all the money within the allotted time, the outstanding balance is considered a distribution and you'll owe taxes on it, and possibly a 10% early withdrawal penalty as this rule will likely come back into effect before the 401(k) loan term is up.
A better choice might be to take advantage of the CARES Act provision that enables you to pay back your COVID-19 distributions over three years. You still have to pay taxes on your distributions, but if you put the funds back within three years, you can file amended tax returns for the years you paid taxes on that money and recoup it. These repayments also don't count toward your annual contribution limit for that year.
Not all employers allow 401(k) loans, and if your company does not allow rollovers, you may not be able to repay your COVID-19 distributions as a lump sum. Check with your company to learn about its policies.
3. Redo your retirement strategy
Whenever you withdraw money from your retirement account, you should redo your retirement strategy so you know how much you must save going forward in order to have enough for retirement. But with some people still out of work due to the pandemic, it might be wise to wait until you return to work and can begin saving for retirement once more to run these calculations. If you make plans now and aren't able to start saving for another few months, your new plan will already be irrelevant.
Figure out how many years you have between now and your chosen retirement date and estimate how long you will live to figure out roughly how many years of savings you need. Then, estimate your average annual spending in retirement, keeping in mind that some costs, like healthcare, will go up in retirement while others, like child care, may disappear. Multiply your estimated annual retirement costs by the number of years of your retirement and add 3% annually for inflation. A simple spreadsheet or retirement calculator can take care of this.
Note how much you still have in your retirement account and estimate how much this can grow to over time. Use a 5% or 6% annual rate of return. Your money may grow more quickly than this, but you won't have to worry as much about not having enough if you plan for slower growth. Subtract this amount from the total cost of your retirement, along with any money you expect from Social Security or a 401(k) match to figure out how much you must save on your own.
If you're not able to save as much as you'd hoped for, you will have to adjust your retirement planning. You can try cutting costs -- either now or in retirement -- or consider delaying retirement to give yourself more time to save while simultaneously reducing the number of years of savings you need.
It's best to look over this plan every year or so, especially if you think you may need to borrow more from your 401(k) or if you plan to pay back a portion of what you've already borrowed.