The COVID-19 crisis has wreaked more financial havoc than many of us could have imagined. Though stocks have managed to thrive despite an early beating, the U.S. economy is still deep in recession territory, and with COVID-19 cases surging in most states, the risk of a second widespread lockdown remains.
All of this is far from encouraging for those who are grappling with income insecurity right now. In fact, if cases don't stop spiking, we may find that unemployment numbers start to climb again. (The numbers in May and June were, thankfully, lower than April's, but daily cases weren't nearly as high back then as they've been in July.)
It's not surprising, then, to learn that some people may be going to extreme measures to compensate for income loss or financial issues that have arisen during the pandemic. In fact, 24% of Americans are now planning to take a withdrawal from a 401(k), according to SimplyWise's July 2020 Retirement Confidence Index. By contrast, in May, only 20% of workers said they'd do the same.
Those who have lost a job during the pandemic are even more likely to raid their retirement savings, with 41% of laid-off workers saying they're looking to go this route. And 23% of near retirees in their 50s are planning on a 401(k) withdrawal, up from 14% just two months ago. While removing funds from a 401(k) might seem like your only option right now, it's one you should exercise with caution.
The danger of taking an early 401(k) withdrawal
Generally, you can't touch your 401(k) until you're at least 59 1/2. Withdraw funds sooner than that and you risk a 10% early withdrawal penalty on the sum you remove.
But that penalty is waived right now if you can prove that you've been impacted financially (and not in a good way) by COVID-19. In fact, you're allowed to remove up to $100,000 from your 401(k) if you need the money, assuming you have that much in your retirement plan to begin with.
At first glance, that's a tempting option. With a 401(k) withdrawal, you won't have to go out and borrow the money, thereby racking up interest on it. You also won't encounter the same rejection you might face if you attempt to secure a personal loan or home equity line of credit.
But if you're going to raid your 401(k) to cover near-term expenses, make sure you really need to and there's not a better option. The problem with taking an early 401(k) withdrawal is that you'll leave yourself with less money for your senior years, when you're apt to need it the most. That's why it's important to leave your savings intact if you can.
Also, when you remove money from a 401(k) or any retirement plan, you don't just lose out on the sum you withdraw -- you also forgo growth on that money. Let's say your 401(k) is invested heavily in stocks, to the point where it generates an average annual 7% return on investment, which is a bit below the stock market's average. If you take a $10,000 withdrawal from your 401(k) to avoid falling behind on your mortgage and other bills, but you're 25 years away from retirement, you'll potentially end up losing out on over $54,000 when you account for lost investment growth.
Of course, if you're really backed into a wall, you may have no choice but to remove money from your 401(k). But in that case, only withdraw what you need. You might have a $100,000 balance, but if you typically spend $3,500 a month on recurring living expenses and you expect to get $2,000 a month in unemployment benefits for the foreseeable future, you might choose to withdraw around $9,000 to cover your remaining expenses for the rest of the year, and then hope you'll be employed by the time 2021 rolls around.
Finally, only withdraw enough to cover essential expenses. If you're looking at raiding your 401(k), now's not the time to be splurging on takeout or new electronics. Rather, withdraw what you need for basics, but aim to leave as much of your savings intact as possible so that you don't wind up struggling financially later in life.