Did you know that part of the recently passed The Coronavirus Aid, Relief, and Economic Security (CARES) Act lets you withdraw $100,000 from your retirement funds without incurring the 10% penalty normally applied for early withdrawal? For a typical family with two working adults, that’s up to $200,000 of funds the government is letting you tap into without being penalized.
The provision didn’t get much coverage in the media, and that’s why not everybody knows about it. Still, having access to this money right now must be very tempting for those who are in limbo because of the shutdown. Is withdrawing now worth it? What are the details?
Raiding Your Retirement Account Due to Coronavirus
Basically, you are allowed up to $100,000 in distributions from qualified retirement accounts for reasons due to coronavirus in 2020 and the IRS won’t levy the typical 10% early withdrawal penalty.
To further sweeten the deal, taxes based on the withdrawal can be spread out over three years to lessen the tax load for any particular year.
And as if the incentives aren’t enticing enough, you also get to contribute the amount you withdraw back into another eligible retirement plan within three years if you so choose.
401k Loans Limits are Increased Too
Those with money in a 401k were always allowed to borrow up to $50,000, or 50% of their vested balance from their plan. Now they are allowed to borrow up to $100,000, or 100% of their vested balance.
Borrowers will need to repay that amount with interest, but the amount won’t be subject to taxes and the interest is credited to their own account.
So What Are You Waiting For?
Tempting right? I know I’ve thought long and hard about taking money out of our retirement accounts even though we don’t need the cash.
This is because we will be required to make withdrawals when required minimum distribution forces us to withdraw, likely bumping our tax rates too high if investment returns resemble anything close to historical norms in the next two decades.
As a tax planning tool, it could be worthwhile for us to move some of that money into a Roth IRA or even taxable accounts.
Here are the negatives though.
1. You are likely going to lose your stimulus money if you take a distribution. Not many people know that the eligibility of the $1,200 stimulus check depends on 2020 income. It’s only because the government has no way to know how much we are making this year until 2021 that they used our most recent income tax filing to determine who to send checks out to.
No one is expecting Congress to claw back the money they’ve already sent out, but you don’t need to take that risk. Also, if you qualify based on current income but didn’t get a check because you made quite a bit in previous years, then you won’t get a check if you opt to increase your tax bill by taking a giant distribution from your retirement accounts.
2. You still pay massive amounts of taxes from any distribution. You get to spread the tax bill out three years, but you still need to pay eventually. You could end up owing $40,000, $50,000 in federal taxes alone.
Add in state taxes and you are talking about a massive drain to your cash flow for the next few years. I live in California, which is another 9.3% down the toilet!
3. And speaking of state taxes, no states have said anything about how they will handle the distribution. I doubt states will venture out on its own and not follow the leeway provided by the Federal government, but anything can happen these days. California normally takes another 2.5% as an early withdrawal penalty. Are you going to risk letting your state take another chunk from what’s rightfully yours?
4. You might end up sitting on the sidelines not invested for years. I was going to immediately plow any distribution back into the markets to make the withdrawal market neutral, but most people taking distributions are probably going to be out of the market for a while.
When you are out of the market, it’s extremely hard psychologically to buy back in when volatility is high. Sure, you might get lucky and miss a huge decline, but what if you end up on the sidelines for years afraid to get back in while the market grinds its way ever higher?
5. You lose out on years of tax-deferred growth. Even if you put that cash immediately into the markets, taxable accounts don’t get tax-deferred growth. That means capital gains taxes, and taxes on dividends for decades on this withdrawal.
6. Most 401k plans allow hardship withdrawals, but plans aren’t required to allow them. You need to check with your plan administrator to make sure you can actually take money out before you make any definite plans for the money if your plan is to take it out of a 401k.
Not every 401k plan allows participants to take money out while they are still employed. The percentage of plans at small companies that allow them is even lower.
7. 401k plans may make you take a loan out first. While you are verifying what the rules are, make sure you ask whether you can take the money out or if you need to take out a loan first. 401k plans are governed by a plan document, which could be an ancient document created years ago when the plan was first established.
Don’t assume the plan is updated with anything that is helpful for pandemic times.
8. You need to trust that your 401k plan administrators handle the paperwork correctly. You not only need to trust that the plan administrator actually knows what you are requesting, but you also need to assume that he/she correctly handles the paperwork and sends you the correct 1099s at year-end.
I feel bad saying this, but I’m telling you based on other people’s frustrations dealing with some 401k plan administrators that you could end up with a major administrative headache due to incompetence.
9. Splurging with some of that money will be extremely tempting. Nothing screams “buy something” quite as loud as $200,000 hitting the bank account all at once.
Everyone can be calm during the planning phase, but how will you react when your checking account suddenly swelled to a never before seen level? Don’t underestimate how the mind can play tricks on us.
10. This may increase the chances your tax returns are audited in future years. Only people affected by the Coronavirus can get the 10% penalty waived. That’s why you need to keep records to prove you were affected just in case the IRS sends you a notice asking why you are eligible. This is a minor hassle, I admit, but an annoyance nonetheless.
11. Money in a retirement account provides strong asset protection. 401k plans are generally protected from creditors, bankruptcy, and civil lawsuits under the Employee Retirement Income Security Act (ERISA).
IRAs are less protected, but the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 still protect the funds from bankruptcy. Some states even protect IRA assets from creditors. Take that money out and the amount is subject to any judgment against you.
I was shopping for mortgages recently and even lenders won’t count retirement account assets when trying to qualify you for mortgages because they won’t be able to get anything you stashed away to pay off the mortgage if you default.
The protection is strong and already tested in court. Don’t underestimate how valuable protection might be if you were to need it.
What’s the Plan Forward?
After thinking things through, I don’t plan to take money out for now. Aside from not knowing how California is going to treat the distribution, I also have at least a few more months before the deadline passes. I have time to change my mind if more clarity emerges.
But what about you? If you are thinking about raiding your retirement account, you should think everything through carefully. It’s one thing if you need the money, but you better make sure your math is right if you are doing it for tax planning purposes.
Additionally, realize that you are making a bet that the hassle is worth the effort. This is because you really don’t know how much you’ll earn in the next few years and what the tax brackets will be in the future.
Who knows what’s going to happen next year or in 2022? Maybe you’ll make lots of money and be in a high tax bracket, or maybe Congress will decide to gift everybody basic income for a year, increasing everyone’s taxable income. There’s been talk for years how income tax rates are probably at its lowest in our lifetime, but there are no guarantees that the government won’t lower them further in the future.
If the last few months offer any indication, it’s that there’s a strong desire in Congress to give main street a break due to the pandemic.
Are you still planning to take money out of the retirement accounts this year due to the Cares Act? Does it make sense? Let us know!
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Taking out money from a retirement account doesn’t seem to be a great idea! Nicely explained! But, if one needs money, it’s hard to resist any viable source available.
It sure is hard, but resist you must!
I like that you brought up moving retirement money into taxable accounts. I almost exclusive used Roth accounts for retirement if for nothing else that way I can know how much I have, not how much I have before Revenue Service, first name Internal comes knocking. I think people forget that Roth accounts are invested with after tax money meaning. That means there are no taxes when you retire, and no tax penalty for withdrawals of your contributions. In fact, Roth accounts avoid almost everything you brought up. Taxes, RMDs, those terms do not apply to a Roth. Nothing a Roth can do mediate opportunity costs, they aren’t pure magic.
You should consider the pre-tax accounts like 401k and IRAs after you max out your Roth too.
If you make the calculation, you might be surprised to find that you have quite a bit of room to pay almost no taxes once you stop working even if you start withdrawing from your retirement accounts.
This was needed. I was thinking of taking out money from the retirement fund. Now, I’ll reconsider.
Good to think twice about this Abigail. Let me know if you have any other questions!
yes,
we need to be careful in this particular thing.
Thanks for sharing
Having my money protected from creditors is the main reason why I want more of my cash in a 401k. In the event I wake up one day and find out my husband applied for a bunch of loans I didn’t know about, I wouldn’t have to work to pay it off for the rest of my life.
Better safe than sorry Carol!
Hopefully you won’t need it but asset protection is powerful. In the meantime, enjoy the peace of mind that it provides.
The cliff notes is that you should never take money out of your retirement account to fund bills, but tell that to my creditors and family.
When I need money, I need money. I’m certainly not going to starve while I have a million dollars in my 401k. Do you think it’s a good idea to instead rack up tens of thousands of dollars in credit card debt? Don’t think so!
I understand your point of view, and that’s why so many have already tapped their retirement account. I just wish they would consider all possible resources before they make that withdrawal, and also to not take everything out as soon as they are able.