Millions of Americans have lost their jobs in the course of the COVID-19 outbreak, and even those who are working may be grappling with financial concerns. If you're finding yourself needing money but don't have much in the bank, you might assume that your next best bet is to tap your retirement savings.
Generally, taking a withdrawal from an IRA or 401(k) prior to age 59 1/2 triggers a 10% penalty on the sum you remove. But thanks to the CARES Act, which was signed into law in late March to provide COVID-19 relief, you can now remove up to $100,000 from your retirement savings if you've been impacted by the pandemic. And the interpretation of the latter is somewhat loose. You'll qualify, for example, if you're still working but have a spouse who's lost income.
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At first glance, taking a CARES Act withdrawal might see like a solid move, especially if money is tight and your borrowing options are limited. But if you do decide to take money out of your retirement plan this year, you may wind up with a tax headache on your hands.
Will a CARES Act withdrawal bump you into a higher tax bracket?
If you remove money from a Roth IRA or 401(k) under the CARES Act, you won't have to worry about paying taxes on your distribution. But if you take a withdrawal from a traditional IRA or 401(k), taxes on that sum will apply, as they normally would for distributions taken during retirement.
The good news is that the CARES Act does allow you to spread those taxes out over a three-year period from the time of your withdrawal. The bad news, however, is that you could get bumped up to a higher tax bracket in the interim, whether you spread that extra taxable income from your distribution out over three years or take it all in a single tax year.
Here's what that could mean for you in practice. Say you're a single tax filer with an income of $80,000. That puts you in the 22% tax bracket, which means your tax rate is 22% on your highest dollars of earnings. Now, let's say you take a $30,000 CARES Act withdrawal from a traditional retirement plan and you decide to spread that distribution out over three years. That still adds $10,000 of taxable income each year, thereby bumping you up to the 24% tax bracket in this example. Or to put it another way, it makes your tax burden even worse at a time when you probably can't afford it.
Be careful when taking a CARES Act withdrawal
You may feel that you have no choice but to remove money from your retirement savings to address your near-term bills or financial concerns. But if you decide to go this route, be aware of the tax consequences involved.
Another thing you should realize is that every dollar you remove from your IRA or 401(k) today is money you won't have available to you as a senior, when you may need it the most. And any withdrawal you take is also money you can't invest and grow into a larger sum. Therefore, while a CARES Act withdrawal might seem like a lifeline, think carefully before you move forward with one.
