Throw Out the Old Rules of Raiding Your 401(k) for Cash

As the economic crisis drags on and savings account balances continue to drain, some Americans find their hands hovering over the dreaded third rail of savings to make ends meet: Cashing out their retirement savings.

In BC (Before Covid) times, the advice regarding this last-resort stash of cash was consistent: Any early withdrawal from a retirement savings account = Very Bad. An early 401(k) withdrawal = Bad. Taking out a 401(k) loan = Better, but still not great for your future. Then the The Coronavirus Aid, Relief and Economic Security Act (CARES Act) changed the rules.

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The old advice about tapping your 401(k) for cash

Financial pros have traditionally discouraged straight-up withdrawing cash from a workplace retirement account (like a 401(k), 403(b) or 457(b) plan) because of three costly side effects: 

1. A 10% early withdrawal penalty Uncle Sam demands if you dip into the account before age 59 ½.
2. A 20% upfront tax hit, which the IRS automatically withholds to help cover some of the income taxes you’ll eventually owe. Come tax time, you’re responsible for paying any shortage (as well as state income taxes). 
3. A permanent 401(k) balance reduction. Once you withdraw money from the account, there’s no going back: You lose any opportunity to put those dollars back into the tax-advantaged haven of your 401(k). Plus, you lose any earnings that money would have amassed had it stayed put.

The rules (in BC times) meant immediately forking over 30% of what you borrowed to the IRS. So a $50,000 withdrawal comes out to just $35,000 in spendable money. (Not to mention the permanent ding to your retirement savings.)

The far superior option to an early 401(k) withdrawal has always been taking out a 401(k) loan. 

You pay no income taxes on a 401(k) loan, as long as you repay the money within a certain amount of time. (Terms vary by plan, but you typically have up to five years.) Your retirement savings takes only a temporary hit because you’re eventually paying back the money. In the meantime, you’re paying yourself interest on the amount you borrowed.

You can see why a 401(k) loan was the preferred option. Just one problem: Not all 401(k) plans allow employees to take out loans. And right now, people need options.

Enter the COVID-19 401(k) withdrawal workaround. 

The new thinking on early 401(k) withdrawals

The CARES Act essentially turned 401(k) withdrawals into 401(k) loans for those who need just a temporary influx of cash. And in many ways, the terms are more flexible if you’re short on funds. Play your cards right and you can score a three-year, interest-free loan. Here’s how the new rules of early 401(k) withdrawals work:

You get the entire amount you need upfront: Both the 10% early withdrawal penalty (if you’re under age 59 ½) and the 20% standard withholding rules have been suspended.  

You can access more of your money: The CARES Act doubled the cap on how much you can take out of your employer-sponsored retirement account to $100,000 from $50,000. (It’s the same for loans, btw.)

You can turn your 401(k) withdrawal into a 401(k) loan: This is big. If your fortunes turn around and you’re able to pay back the amount you took out (even just some), you’re allowed to replace the money you took out. You have three years to pay yourself back. 

 You can spread income tax payments over three years — and get it back from the IRS: You will still owe income taxes on your 401(k) withdrawal. However, the IRS allows you to spread your income tax payment across three years. And if you do replenish your 401(k), the IRS will refund any income taxes you paid on the money. Altogether, the new 401(k) withdrawal rules allow you to borrow money for three years at 0% interest and pay no taxes. 

The $66,000 cost of not paying it back

The temptation to take the money, pay your taxes and put the entire episode in your past may be strong. Try to resist: That decision can have a huge impact on your future.

Here’s a Fidelity 401(k) loan example: It starts with an employee who contributes 5% of her salary to her company 401(k), gets the employer match and earns an average annual return of 4.5% until age 67. At age 45 she has $38,000 in her account and needs to withdraw $15,000. (This is in pre-CARES Act times, which requires withdrawing nearly $24,000 to cover penalties and taxes to get $15,000.)

If she never pays back the amount, in 22 years when she retires her balance will be $362,913. That includes a 6.5% loan interest rate she pays herself. But if she repays the $15,000 loan during the five year term, her 401(k) will grow to $429,725 — or $66,812 more, thanks to her investment growth compounding.

It really pays to think through not just your immediate needs, but long-term financial plans as well. If you think you’ll need more time than the three years the new 401(k) withdrawal rules allow, a 401(k) loan is a better option. Remember, with a withdrawal you have just three years to replenish the account to avoid owing income taxes. 401(k) loans provide more time before non-payment turns into a taxable distribution. And the CARES Act granted a one-year extension to the employer-established payback deadline. For many, that means up to six years to pay off the loan. 

The bottom line

The CARES Act makes it a lot less financially fraught to tap into your retirement savings to make ends meet. Just make sure you’ve exhausted your other options — such as cutting back expenses (even stopping 401(k) contributions for a while) to free up cash. 

The first step is to make sure your employer has adopted the CARES Act provisions. (If not, inquire about existing 401(k) loan rules.) And make sure that you can show that you qualify, which requires showing that you’ve suffered financially because of the pandemic. That can be anything from having a partner be unable to contribute as much to the household’s income (due to a layoff or reduced hours), childcare closures, or having to care for yourself or a sick family member.

If you decide to tap into your 401(k), come up with a payback plan. With a 401(k) loan, your plan administrator will set up the loan payment schedule and terms. Since you’re not required to make loan payments on a withdrawal, you’ll need to act as your own plan administrator and set up a personal repayment schedule.

You want to get your money back into the account and growing for your future as soon as you’re able.

MORE ON HERMONEY:

• 401(k) Loan vs. Hardship Withdrawal
• These Two Examples Illustrate the Magic of Compound Interest
• Podcast: Suze Orman and Jean Chatzky on Coronavirus, Your Retirement and Recession Fears

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