Over the past several months, 401(k) plan participants have asked about taking advantage of pandemic-related CARES Act changes to retirement account withdrawals. Although the CARES ACT has made it easier to withdraw funds, this should only be done as a last resort. Steps can be taken to prevent the need to tap into funds allocated for retirement. Here’s what we’ve been telling our 401(k) clients.
CARES Act Changes
Earlier this year, the CARES Act temporarily waived the penalty for coronavirus-related withdrawals, allowing investors to withdraw up to $100,000 from their retirement accounts. The CARES Act allows qualified individuals who have been financially impacted by the coronavirus pandemic to pay back funds withdrawn from a qualified retirement plan over a three-year period.
According to the IRS, early withdrawal distributions can be included as income over a three-year period, starting with the year in which you receive your distribution. For example, if you took a $30,000 coronavirus-related distribution in 2020, you would report $10,000 in income on your federal income tax return for 2020, 2021 and 2022. However, you also have the option of including the entire distribution in your income for the year of the distribution.
Downsides to Early Withdrawals
Individuals who take an early withdrawal from a retirement account before turning 59 1/2 typically face a steep 10% early withdrawal penalty, plus potential tax implications. Even though the pandemic has made it easier for many Americans to take money out of their 401(k), SEP, and traditional IRA accounts, it’s not a good idea to treat a retirement account like a savings account.
Early withdrawals from a retirement account could miss out on significant future market gains, in addition to the risk of selling low to then buy high at a later date. Assuming a 7% annual rate of return, today’s retirement account balance of $5,000 could be worth more than $50,000 in 35 years.
Every dollar counts – and timing is critical – when it comes to saving for retirement. Taking money out of a retirement account early will require you to save even more in the future, which could compromise or even jeopardize your retirement plan.
In addition, remember that taxable retirement distributions are, in fact, considered income by the IRS, which means that early distributions can be subject to higher IRS income tax rates. If you choose to take an early distribution, you may inadvertently end up in a higher tax bracket, with a greater percentage of the money you’re “borrowing” from your 401(k) account being spent on taxes.
Preventing the Need for Early Withdrawals
The next period of financial distress won’t look like the last, but everyone should be prepared for when it happens again. Fortunately, there are several steps you can take to prevent premature withdrawals from your retirement accounts.
Create an emergency fund. Although credit cards may be a convenient way to cover unanticipated expenses, those bills will eventually come due. Unfortunately, most Americans don’t have enough money set aside for an emergency fund. Bankrate.com recently reported that nearly 25% of Americans have no emergency savings and that nearly one-third of households have reported lower income since the start of the pandemic. Try to set six months of expenses aside, in the event of an emergency, from home repairs to pandemic-related medical treatment. You never know when you might need it.
Apply for a line of credit before you need additional funds. If you don’t have an emergency fund, think about applying for a line of credit. This could allow you to access cash quickly and easily in the event of a major unforeseen emergency – without disrupting your retirement plan. Your financial situation will likely be better before needing the funds, so applying now should improve the chances of being approved.
Analyze Your Budget and Spending
Even in the best of times, it’s important to have detailed knowledge of your cash flow. Having a household budget allows you to track your discretionary and non-discretionary spending. Determine which expenses could be cut back in the event of an emergency and which expenses are necessary. It’s much easier to remove or delay discretionary spending, and planning ahead will make the decision even easier if the time comes.
These proactive steps for our 401(k) participants incrementally strengthen their financial moats for unexpected events. Although the CARES Act has made it easier to withdraw from retirement accounts, this should only be done as a last resort. Taking these steps should help prevent the need to tap into these funds and help avoid the hefty costs of doing so.
Need help with your 401(k) plan? Please reach out to us for guidance.