You know you should only touch your 401(k) for non-retirement purposes in a worst-case scenario.
For many people that time is now. At least 30 million people have lost their jobs due to coronavirus, and many have found that expanded unemployment benefits have been painfully slow to materialize.
The $2.2 trillion CARES Act made it easier to use your retirement savings if you’ve been diagnosed with COVID-19 or have suffered financially due to the virus. For example, if you’ve been laid off, your hours were cut or you had to close your business due to the virus, you’d qualify.
And while we don’t love the idea of taking money out of retirement funds, we get it: This is a time when a lot of people are looking at less-than-ideal options.
What Are the CARES Act Rules for Using Your 401(k)?
Usually, you pay a 10% penalty on early 401(k) withdrawals, which are also known as distributions. The CARES Act waives that for coronavirus-related withdrawals up to $100,000 or 100% of your vested balance, i.e., the balance that’s yours to take with you if you leave your company. You can spread the income tax bill over three years, and you have the option to repay your plan over three years.
You can also borrow up to $100,000 or 100% of your vested balance if you’re impacted by coronavirus. That’s double the $50,000 maximum that usually applies to 401(k) loans.
While you typically repay a 401(k) loan back over five years, the CARES Act lets you hold off on making payments for a year. If you already have an outstanding loan, your plan can allow you to suspend payments for the rest of 2020.
Note that your employer sets the rules for 401(k) early withdrawals and loans. The CARES Act doesn’t change that. Your employer may decide not to allow certain CARES Act provisions.
For example, your plan may not allow the increased loan limits (or it might prohibit loans altogether), or it could opt not to let you repay a withdrawal.
Even if your employer won’t treat a distribution as coronavirus-related, you can still report it as such when you file your 2020 tax return, according to an IRS FAQ.
6 Ways to Limit the Damage if You’re Taking Money From Your 401(k)
Here’s how to mitigate the damage if you’re taking money from your 401(k) to survive the coronavirus crisis.
1. Ask for a Coronavirus Withdrawal, Not a Hardship Withdrawal
If you’re considering a withdrawal, make sure you ask your plan administrator for a coronavirus-related withdrawal under the CARES Act, rather than a hardship withdrawal.
With a hardship withdrawal, you’ll often still pay the 10% penalty if you’re under age 59 ½, plus your employer will withhold 20% for taxes. Not only does the CARES Act waive the 10% penalty, but there’s no mandatory tax withholding. (See #5, as not planning for taxes could come back to bite you.)
2. Only Take Out What You Need to Stay Afloat
The CARES Act allows you to withdraw or borrow up to $100,000 — even if your coronavirus-related losses are way less than that.
If you’re considering a withdrawal or loan, we’d urge you to stick to what you need to stay afloat. That means take what you need to buy groceries, maintain your health insurance and stay current on bills, but don’t use your 401(k) for other reasons, like paying off a mortgage or funding a big purchase.
By keeping as much money in your account as possible, you’re giving your money time to recover from the nosedive the market took in March.
Provided that your plan allows it, you could always take another withdrawal should you need it. Loans, however, are a different story, as many employers don’t allow you to have more than one at a time.
3. Avoid 401(k) Loans if You’re Worried About a Layoff
One of the big risks of a 401(k) loan is that if you leave your job for any reason, you’ll have to pay it back sooner. The CARES Act doesn’t change that.
If you leave your job, you’d have until you file your tax return for the year to repay your plan. Otherwise, it’s treated as a distribution — one that isn’t subject to the breaks you get under the CARES Act. That means you’d pay a 10% penalty, plus owe the entire tax bill.
Most plans don’t allow you to take a 401(k) loan if you no longer work for the company, so this probably won’t be an option if you’ve lost your job.
4. Do an IRA Rollover if Necessary
If you’ve lost your job but you’re still in your old employer’s 401(k) plan, you still need to follow the plan rules. If your plan doesn’t allow coronavirus distributions, you can roll over your balance to an IRA and take the withdrawal from there.
Two things to note: A 401(k) rollover is only an option if you’re no longer working for the employer. And you’d need to take a withdrawal from your IRA, because long-term IRA loans (over 60 days) aren’t allowed. While you can’t take an IRA loan, you can still pay back your IRA over three years if you take a coronavirus distribution.
If you have a Roth IRA, consider tapping into that before your 401(k). You can always withdraw your contributions (but not the earnings) without taxes or penalties.
5. Make a Plan for the Tax Bill
Back to those tax withholdings: While there are no mandatory withholdings for coronavirus distributions, there’s a 10% voluntary withholding that you can waive. Think very carefully before you opt out. You’re going to pay taxes on this money at some point.
A distribution will be treated as ordinary income at tax time. That means if you withdraw $30,000 and opt to spread the taxes over three years, $10,000 would be treated as income for 2020. Consider setting aside enough money from a withdrawal to pay your 2020 tax bill on the withdrawal.
6. Make Repaying Your Withdrawal a Priority
Let’s look forward to when your finances begin to recover. Your first priority will be to get current on any bills you haven’t been able to pay.
One great feature of the CARES Act is that you can pay back your 401(k) after taking a distribution, which isn’t typically allowed. Once you’ve caught up, repaying the money you withdrew from your plan needs to take top priority.
Work whatever you can afford to pay into your monthly budget, and put getting back on track for retirement ahead of other goals.
The good news is that paying back your plan won’t affect your 401(k) or IRA contribution limits.
If you’re taking money out of your 401(k), you’re borrowing from your future self. In times like these, that may be necessary.
But once you’re on stable footing again, you need to make your future self a priority again.
Robin Hartill is a certified financial planner and a senior editor at Codetic. She writes the Dear Penny personal finance advice column. Send her your tricky money questions at [email protected]