COVID-19 has done a number on the U.S. economy, driving tens of millions of Americans into unemployment and causing those with jobs a world of financial stress. Thankfully, relief was made available early on in the pandemic. In late March, the CARES Act was signed into law, and it included one key provision that, when exercised, could really bail Americans out of their financial jam: the option to take penalty-free withdrawals from a retirement savings plan.
Normally, IRA and 401(k) withdrawals taken before age 59 1/2 are subject to a 10% early withdrawal penalty. The reason? Savers get a tax break on their contributions and investment gains, so in return, they're asked to leave their money alone until retirement. Those who don't abide by that rule get penalized.
But under the CARES Act, savers can take a withdrawal of up to $100,000 if they've been affected negatively by the COVID-19 outbreak, and that withdrawal won't be subject to penalties at all. But interestingly enough, most people have not exercised the option to remove $100,000 from retirement savings. In fact, the majority of savers didn't take a coronavirus-related distribution at all.
Retirement savings are largely intact
Though the option to remove funds from an IRA or 401(k) without penalty is a good one to have in theory, the fear is that many workers will deplete their retirement savings prematurely and then wind up with inadequate funds later on. But so far, coronavirus-related withdrawals have been minimal.
Vanguard reports that only 1.9% of savers took a retirement plan withdrawal through the CARES Act through May 31. Of those who did, the median distribution amount was $10,413. Furthermore, nearly 30% of distributions taken because of coronavirus were under $5,000, and only 4% took the maximum $100,000 withdrawal.
All of this is very good news. The less money workers remove from their savings today, the more they stand to retire with. And also, lower withdrawals equate to less missed investment growth.
Imagine a 35-year-old saver removes $5,000 from an IRA to cover near-term bills, but normally generates an average annual 7% return on investment in his or her account. If that same person retires at 65, he or she will actually end up with $38,000 less in savings when lost investment growth is accounted for. That's why it's so important that those who are tapping their retirement savings for COVID-19-related necessity withdraw as little as possible, despite the option to remove up to $100,000. Doing so will help minimize the damage to their long-term plans.
Also, with a traditional IRA or 401(k), there's a tax component, too. Though Roth account withdrawals aren't taxed, traditional retirement savings plans are subject to taxes on distributions. To be clear, that's not a penalty -- these taxes apply during retirement as well. The CARES Act allows taxes on an emergency retirement plan withdrawal to be paid over a three year time period, but the fact that those taxes come into play is yet another reason for savers to take as little out of their IRAs or 401(k)s as possible.