COVID-19 is not just a public health crisis; for many people, it's a financial nightmare. Over the past three months alone, millions of Americans have lost their jobs, countless small businesses have permanently closed their doors, and retirees have been forced to make hard decisions as their savings have lost significant value.
Thankfully, there's been some relief. Under the CARES Act, which was passed in late March, Americans whose income fell below a certain threshold were eligible for a one-time $1,200 stimulus payment. The CARES Act also boosted unemployment benefits, extended the number of weeks claimants could collect them, and relaxed the rules on retirement plan withdrawals so that desperate Americans could tap their savings early if necessary.
That last one is an option some workers are taking advantage of. An estimated 13% of workers have withdrawn funds from a 401(k) or 403(b) due to the effects of COVID-19, while 4% have tapped an IRA, according to a recent survey by Principal. But while taking money out of a retirement plan might seem like a reasonable solution to pandemic-induced financial woes, it's a move you might really regret after the fact.
The danger of tapping your retirement savings
Normally, removing funds from a retirement plan before age 59 1/2 results in a 10% early withdrawal penalty. But the CARES Act waives that penalty for those affected financially by COVID-19.
That's good in theory. Not everyone has the credit needed to qualify for a loan, and those without property to borrow against (like a home) could find themselves with limited choices for affordable loans. Allowing Americans to simply access their own savings during a crisis therefore makes sense. But it's still an option you should really try to avoid.
For one thing, the more money you remove from a retirement plan today, the less you'll have as a senior, when you might need it even more. And it's not just the principal you withdraw that won't be available in retirement; you'll also lose out on investment growth.
Imagine you're 40 and retirement is a good 25 years away. If you remove $5,000 from your retirement plan today to cover some immediate bills, you'll clearly be out $5,000 later in life. That may not seem so bad, but don't forget that if the investments in your retirement plan typically generate an annual 7% return, which is a few percentage points below the stock market's average, you'll actually end up $27,000 short as a senior when you factor in lost investment growth.
Also, many people lost money in their retirement plans when the stock market crashed earlier in the year. If your IRA or 401(k) hasn't yet recovered, and you take an early withdrawal, you'll risk locking in losses you could have otherwise avoided by waiting things out.
The takeaway? If you really have no choice but to withdraw from your retirement savings to make up for lost income, do it. But that should also be your absolute last resort. If you can't borrow affordably to keep up with your bills, try asking for relief. Your landlord, for example, might allow you to defer rent payments until you're back on your feet, while your utility providers might give you added time to pay as well. Raiding your retirement savings out of desperation is a move that could really hurt you in the long run, so make sure it's truly necessary before taking a withdrawal.