Invest Retirement

401(k) Loan vs. Hardship Withdrawal: New CARES Act Rules Make it Tempting

Dayana Yochim  |  April 21, 2020

New CARES Act rules for early 401(k) withdrawals make it easier to raid your retirement savings and blurs the line between loans and hardship distributions.

You need money and you need it now. The Coronavirus Aid, Relief and Economic Security Act (CARES Act) makes it easier and less financially punishing to withdraw money early from your 401(k) or other employer-sponsored retirement plan. But before you raid retirement savings, know the new rules about 401(k) loans versus 401(k) hardship withdrawals. And, know yourself. 

Withdrawing money from your 401(k), 403(b) or 457(b) plan is a slippery slope, says CFP Jeanne Fisher, managing director of Strategic Retirement Partners in Nashville. “The initial taking of the loan isn’t the issue — the issue is if it becomes a habit,” she says. “You don’t want to establish a habit of using your retirement account as a short-term loan agency.”

That said, never before have early 401(k) withdrawal terms been better for those in dire need of cash: 

  • Gone is the 10% early withdrawal penalty on coronavirus-related distributions made in 2020 if you’re under age 59 ½. 
  • The new legislation also doubles the maximum you’re allowed to take out of your 401(k)  from $50,000 to $100,000, or 100% of your vested balance, whichever is less. 
  • The standard 20% federal tax withholding on distributions has been suspended. That means you get the entire dollar amount of your early withdrawal upfront.
  • The rules for 401(k) hardship withdrawals make them more like 401(k) loans than a direct and permanent hit to your nest egg. 
  • And there are some circumstances that enable you to completely eliminate paying income taxes on an early distribution, essentially scoring a three-year, interest-free loan. 

Before you check your available balance, remember — all the downside risks of early 401(k) withdrawals still apply. Cash out now and you’ll be locking in your losses at the worst time possible, missing out on the multiplying effect of compound interest (and likely the market’s eventual recovery), and siphoning money from your future wellbeing. 

But, if you must, here’s how to minimize the short- and long-term fallout of cashing out your 401(k).

A 401(k) loan is your best option

Here’s what makes a 401(k) loan better than taking a 401(k) hardship distribution: 

  • With a loan, your retirement savings takes only a temporary hit because you’re eventually going to replenish your account. In the interim, you’re paying yourself interest on the amount you borrowed. (With a 401(k) hardship withdrawal, you’re not expected or required to pay back the money. And when IRS rules go back to normal, you’re not even allowed to put the money you took out back into your retirement account.)
  • The CARES Act gives you an extra year to pay off your loan, for a total of six years if you take out a loan in 2020. The legislation also extends the repayment deadline on existing 401(k) loans by one year. 
  • You also get a reprieve on loan repayments. You have a year from when you took out the loan to start paying it back Instead of having to start making payments right away. If you already have a 401(k) loan you can suspend any payments due between March 27 through the end of the year. (Note that interest and administrative fees will continue to accrue during the payment break.)
  • You only pay income taxes if you default on the loan (e.g. if you lose your job or are terminated and stop making loan payments). But the CARES Act gives you the option to spread out any taxes you owe over three years.

If given the choice between taking a hardship distribution and a 401(k) loan, Fisher prefers the latter. “Taking a loan and staying on a payment schedule is best because you will pay yourself back, and, if implemented correctly, you will avoid taxes and a penalty,” she says. But first …  

Do you qualify? The relaxed rules are all well and good, but they apply only to those who have been adversely affected by the coronavirus pandemic. To qualify, either you or a family member has to have been diagnosed with COVID-19 or suffered a financial blow from being quarantined. In other words, you’ve been furloughed, laid off, or had a household pay cut, or are unable to work because of a loss of childcare.

Does your 401(k) plan even have a loan provision? Not all workplace retirement plans allow 401(k) loans. Nor are they required to start offering employees early access or even adopt the new CARES Act rules. “In my experience, most plans that did not allow for loans prior to COVID-19 are not adding them now,” Fisher says. Larger plans are more likely to have a loan feature. According to data from the Employee Benefit Research Institute, 90% of plans with 1,000 or more participants allow 401(k) loans, versus 30% of plans with 10 or fewer participants.

Fisher does note, however, that most plan administrators are adopting the new 401(k) hardship distribution rules.

What is a 401(k) hardship distribution?

A 401(k) hardship distribution is a way for employees to withdraw money from a workplace retirement plan without any requirement to replace it. “It hurts more than a 401(k) loan because now you’re actually taking seed money out, and you’re not being forced to put money back in,” Fisher says. 

The IRS defines a “hardship” as an “immediate and heavy financial need of the employee.” Expenses that qualify for a 401(k) hardship withdrawal include:

  • Certain medical expenses
  • Costs related to purchasing a principal residence
  • Tuition and related educational fees and expenses
  • Payments necessary to prevent eviction or foreclosure on a principal residence
  • Burial or funeral expenses
  • Certain qualified costs to repair damage of a principal residence
  • Under the CARES Act, individuals experiencing adverse financial consequences from the coronavirus can also qualify for 401(k) hardship withdrawals.

The new rules for hardship withdrawals under the CARES Act erase some of the more onerous features of taking an early 401(k) distribution: 

  • By far the biggest change is that hardship withdrawals are no longer permanent. The CARES Act allows individuals to pay back the money taken out of the account. That’s huge. If you pay it all back within three years you can claim a refund on any income taxes you paid the IRS. 
  • Under regular IRS hardship distribution rules you’re only allowed to withdraw whatever amount was “necessary to satisfy the financial need. Under the CARES Act, the ceiling has been raised to $100,000 or your entire vested amount, whichever is smaller. 
  • The 10% early withdrawal penalty on hardship distributions is being waived, and the formerly mandatory 20% upfront withholding for income taxes has been temporarily suspended. 
  • You still have to pay ordinary income taxes on the distribution if you’re under age 59 ½, but you can spread out your taxes over three years (instead of just one).

Sounds a lot like a 401(k) loan, right? Fisher agrees: “It is a work-around to create a ‘loan-like’ option in the plans that don’t allow loans.” But, she says, there are still some outstanding questions about how repayment of hardship distributions will be handled. For example, will employees be able to repay the money via payroll distribution, or will it be due via a lump sum check? Is there interest being charged on the hardship amount like there is on 401(k) loans? Check your 401(k) plan rules and ask lots of questions so there are no pricey surprises.

Things to know before you raid your retirement account

Before you cash in your retirement savings, try to first exhaust other avenues to access cash, including emergency savings, getting a personal loan, low-interest credit cards and even tapping into a Roth IRA

If you are still facing a financial crisis and need to take a 401(k) loan or hardship withdrawal, here are six things to keep in mind:

  • The $100,000 early distribution allowance is the total, per-person ceiling on withdrawals. It’s not per-account. 
  • The additional year to pay back 401(k) loans doesn’t apply to interest or administrative fees. Those will continue to accrue.
  • Don’t expect to be able to indicate which investments you want to liquidate (e.g. cash or fixed-income investments vs. equity mutual funds). Some 401(k) platforms allow it, but some don’t, Fisher says.
  • Your future tax bill could be onerous. The CARES Act merely suspends the mandatory 20% withholding on early withdrawals, kicking the can down the road. You’ll still owe the IRS income taxes (possibly more than 20%). Plan ahead and set aside cash upfront to settle your future tax tab.  
  • If you part ways with your company, the entirety of your outstanding loan balance comes due sooner. You have until the tax due date of the year following your departure to pay it back. You’ll owe income taxes on any outstanding balance after that. 
  • Lastly, if there’s a chance that you may have to file for bankruptcy, leave your money in your 401(k) where it’s protected from creditors. 

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