Throughout America, many states are slowly reopening their economies after the Great Lockdown necessary to slow the spread of COVID-19. But for some families, the financial damage done by the coronavirus won't end when businesses reopen.
If your household faced an income shortfall or other financial hardship due to COVID-19, you may be considering a 401(k) withdrawal. The government has recognized that many families may want to use this option, and the good news is that it has changed some of the rules to make it easier to take COVID-19 related distributions.
But before you do, there are three rules that apply this year based on the CARES Act that you need to know about.
1. You can withdraw up to $100,000 without penalty
If you're under 59 1/2, a 401(k) withdrawal is normally a costly proposition. That's because you'll owe a 10% penalty on withdrawn funds. But the CARES Act changes that for COVID-19 related withdrawals. You can now take out up to $100,000 from your retirement account without incurring this extra tax on early withdrawals.
The elimination of this penalty removes one of the most substantial burdens associated with taking money out of a 401(k) early. While raiding your retirement accounts is still be a costly proposition because you lose out on the compound interest your money would've earned if it stayed invested, at least you don't incur a huge IRS bill to add insult to injury.
2. You'll owe income taxes on the withdrawal but can stretch out repayment over three years
Although the 10% penalty is waived on up to $100,000 in early 401(k) distributions, withdrawing money from your 401(k) still has tax consequences. That's because, no matter how old you are when you take money out, you'll still be taxed on your distributions at your ordinary income tax rate.
The Act made another important change though -- you can repay the taxes due on your coronavirus-related withdrawal over three years instead of owing the entire amount this year. That provides some financial relief as the taxes on a large distribution can be substantial even without penalties.
Just remember, though, that you're going to have a much bigger tax bill over the next few years if you take advantage of this option. It might be a challenge to come up with the extra money if you've already spent the cash you withdrew. However, you do have one way to avoid owing these taxes, as you'll see below.
3. You can put back the money over the next three years
If you've taken money out of a 401(k), that decision is usually irrevocable. But the CARES Act allows you to put withdrawn funds back over the next three years if you took a coronavirus-related distribution. And if you do that, the money you're depositing won't count against your annual contribution limits and you won't have to pay those ordinary income taxes mentioned above.
This rule change provides a great opportunity to minimize the long-term damage of raiding your retirement account during a financial crisis. Unfortunately, though, there's a risk that you won't have the money to put back over the next couple years. For most people, it's hard enough to make regular annual contributions to a 401(k). It'll only be more difficult if you're trying to replace money you took out while continuing to add more in the future. And if you don't manage to put the money back, the tax bill would come due.
Make sure you understand your options before you act
These special rules apply only if you're taking a 401(k) withdrawal because you or someone in your household experienced hardship due to COVID-19. But even if they apply to you, remember to think about the big picture when deciding if you want to take money out of your retirement plan. Since you're putting your future security at risk, always consider other options before you take this drastic step.