By Shuchita Lotlikar and Jagan Tamirisa
With the advent of the coronavirus (COVID-19) pandemic, the US economy has witnessed a market collapse, pay cuts and hour reductions, job layoffs and furloughs, and more. Investing in a 401(k)-retirement account has always been a great way to grow your money tax-free. During the pandemic, the US government has eliminated penalties for early 401(k) fund withdrawal when the need is related to coronavirus. However, individuals should be cautious before withdrawing funds early from their 401(k) accounts.
Prior to the pandemic, 401(k) investments allowed you to save for retirement with tax-free advantages, under the condition that you did not withdraw funds until retirement (starting at age 59 ½ years). The IRS would levy a 10% penalty for early withdrawal and the individual would also be required to pay income tax on the money withdrawn.
The Coronavirus Aid, Relief, and Economic Security Act (CARES) Act has eliminated the 10% penalty on early 401(k) withdrawals for those impacted by the crisis. Now any withdrawals, or distributions, related to coronavirus are allowed. The law merely requires that the money be a “coronavirus-related distribution.” Anyone diagnosed with the virus is obviously eligible, but so is anyone who is facing adverse financial consequences because of the pandemic, such as an inability to find work or childcare.
Taxes will still be owed on 401(k) distributions because the original contributions were pre-tax, but those taxes can be paid over a period of three years. If the funds are repaid back to the 401(k) account in three years, then no taxes need to be paid. Very tempting. So, the big question is should someone dip into the fund?
Early 401(K) Fund Withdrawal: Proceed with Caution
Many individuals – especially the 22 million Americans who have filed for unemployment insurance claims as of April 16, 2020 – will be tempted to dip into their 401(k) retirement funds. And there may be serious reasons to do so, such as medical or personal emergencies, educational expenses, or other large purchases. But it is recommended that one proceed with caution before deciding to make an early 401(k) withdrawal.
The general rule of thumb is that if you can meet your expenses, then leave your 401(k) funds alone. These funds are for retirement, and you should not use them unless you are facing a true emergency. The negative impacts of early withdrawal can include a decreased rate of return, depressed value of stocks, and needing to working for a few extra years to recoup losses.
Perhaps, a better alternative is to take a loan on your 401(k) retirement money. The CARES Act allows individuals to borrow up to 100% of their vested account balance, or $100,000, whichever is less (an increase from the original 50% of your account balance, or $50,000, whichever was less). The borrowed money can be paid back in installments, and payments can be suspended for up to a year. Also, if an individual has an existing 401(k), loan repayment is suspended from the date of the act until December 31, 2020. However, interest will continue to accrue during this period.
In the case of retirees, the act has suspended minimum required distributions, hence relieving retirees from booking huge losses by taking out money during these pressing times.
While it may be tempting to take advantage of new COVID-19-related rules for early withdrawal of 401(k) retirement funds, the consequences of such a decision can be far-reaching. Unless you are facing a true emergency, it may be more prudent to take out a loan on your 401(k) money. Contact our experienced Chugh, LLP professionals for help navigating the complicated financial, tax, and legal implications of the coronavirus pandemic.