Tapping into retirement savings doesn't have to be 'the end of the world.' How to decide if it's right for you
If your income has taken a hit during the coronavirus pandemic, you may be trying to figure out ways to bring in some cash.
One option is to tap your 401(k) plan or individual retirement account under the new rules enacted in the federal coronavirus stimulus package, or CARES Act.
Experts often say taking money from your retirement account is a "last resort," but these days it may be a lifeline to those who have been impacted by the crisis.
"There is a real clear need for people to tap into whatever resource they have so they can continue to pay bills," said Nathan Voris, senior managing director of business strategy at Schwab Retirement Plan Services.
In fact, 27% of those working or recently unemployed have already taken a withdrawal from their retirement savings accounts or plan to use them as a source of income, according to a May survey by Bankrate.
The CARES Act allows those impacted by Covid-19 to take distributions from employer-sponsored 401(k) or 403(b) plans, as well as IRAs, without being penalized. Typically, if you take a distribution before you turn 59½, you are hit with a 10% penalty. Under the new legislation, you'll still owe income tax on the money, but it can be spread over three years. If you repay the money within that time period, you can avoid the tax.
You can also take out a loan from your 401(k). Under normal circumstances, you can take up to $50,000 or 50% of your vested account, whichever is less. The CARES Act temporarily upped that to $100,000 or 100% of your vested account, whichever is less.
Whether or not it is the right move for you depends on your circumstances.
"It really comes down to a lot of personal preference and personal situation," Voris said.
"It is not always bad," he added. "Many times this is the only bucket of money for an individual, or certainly the largest, and access to that is important."
Here's what you need to know before you tap your retirement savings.
Determine your needs
First, take a look at your budget.
"Start with the income coming in and put down all of your absolutely necessary expenses, such as rent, car payment, health insurance, loans and food," said Chad Parks, founder and CEO of Ubiquity Retirement + Savings.
If you have a negative balance and don't expect a change in situation anytime in the near future, then come up with what you'll need to get by for six to nine months, he advises.
So, so if you have a $1,000 a month deficit, plan on borrowing $6,000 to $9,000.
Make sure your plan allows it
There is no guarantee that your employer-sponsored 401(k) plan will allow coronavirus-related distributions. Check to make sure your plan is offering the feature, said Voris.
Nearly two-thirds (63.5%) of plan sponsors are allowing participants to take the distributions, according to a recent survey by the Plan Sponsor Council of America. However, only 36.5% have increased loan amounts to $100,000 or 100% of the vested account. The organization polled plan sponsors June 2 to 16 and received responses from 137 companies.
CARES Act restrictions
In order to take the distribution or the increased loan amount, you or your family must be financially impacted by Covid-19.
That means either you, your spouse or dependents have been diagnosed with the disease, or you are experiencing "adverse financial consequences" as a result of being quarantined, furloughed, laid off or having had your hours reduced. It also applies to those who have been unable to work because of lack of child care or if you had to close or reduce the hours of your business.
Recently, the IRS recently expanded eligibility. If you have had a job offer rescinded or the start date pushed back due to the virus, you can also now take a withdrawal. Additionally, if your spouse has lost a job or a job offer, you may take the distribution.
Distribution vs. loan
If you qualify, a distribution will give you more flexibility over a loan, Voris noted.
Most of Schwab's clients, 98%, have not taken any action since the first quarter. However, those who did chose a distribution over a loan.
"The flexibility allows you to pay it all, or some, back and spread out tax liability over multiple years," Voris said.
"It is a good option for someone who is looking to plug a hole."
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If you need a more structured repayment system, consider a loan.
The same goes if you don't qualify for a coronavirus-related distribution, since you'll be penalized for any withdrawals you make if you are under 59½. (Unless you left your job, in which case you won't be penalized if you are 55 or older). In this case, you'll be subject to the traditional loan limits of $50,000 or 50% of your vested amount, whichever is less.
Beware of pitfalls
If you take a distribution and don't pay it back, that is less money for retirement. You'll lose out on compound interest growth, which is your interest earning interest.
Many people often lower the automatic contributions to their 401(k) plans when taking out a loan, Voris pointed out. That will lower your savings rate over time.
"That can have a real negative impact over a number of years on the income you'll be able generate for retirement," he said.
There is also the possibility of defaulting. If you leave your job, you'll have to make good on the balance, typically within a tight time frame. If you fail to pay it back, the loan will then be considered a distribution. It won't convert to a coronavirus-related distribution and you'll pay the 10% penalty.
"Unless you have good job security and you know for sure that nothing is going to happen, I tell people to be very cautious taking 401(k) loans," Parks said.
Reach out to your plan provider or another financial professional to make sure you understand how a distribution or loan will impact your financial well-being.
Also, remember that your 401(k) or IRA may not be your only resource. Make sure you consider alternatives, such as credit cards or other savings you may have.
However, taking money from your retirement account "is not the end of the world and sometimes can be the right financial decision," Voris said.
"It's all about making a thoughtfully informed decision."
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