Early Withdrawal Rules are Relaxed, but Should You Take Money from Your IRA or 401(k)?

Early Withdrawal Rules are Relaxed, but Should You Take Money from Your IRA or 401(k)?

August 13, 2020
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Typically, you must be over 59 ½, to withdraw funds from your retirement plan without paying an early withdrawal penalty. But, the government has relaxed the rules a bit to help Americans during the coronavirus pandemic. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) allows you to take early withdrawals from retirement plans before the age of 59 ½ without a 10 percent penalty if you’re going through financial hardship due to the COVID-19 pandemic.

There are three ways the relaxed early withdrawal rules can help you:

If you find yourself in a financial bind due to COVID-19 and you’re under 59 ½:

  • You can withdraw funds from your IRA and defined benefit plans (like 401(k)s and/or 403(b)s without paying the 10 percent early withdrawal penalty.
  • You aren’t subject to the mandatory 20-percent withholding rule if you’re making that withdrawal from an employer-sponsored plan, either.  
  • Income tax on a Covid-19 related distribution can be paid over a period of three years.

Taking an early withdrawal can provide some much-needed financial relief. However, there are stipulations. You must meet the criteria.

Criteria to Avoid Paying Early Withdrawal Penalty

 You can borrow up to $100,000 between January 1 – December 31, 2020 if you meet one of the criteria below:

  • You, your spouse and/or dependent have been diagnosed with COVID-19.
  • You are experiencing financial hardship due to being quarantined, furloughed/laid off, and/or reduction of work hours.
  • You cannot work because you have no childcare alternative.
  • You had to close a business (or reduce the operating hours) due to COVID-19.
  • You’re experiencing other financial hardship as defined by the treasury secretary.

You Have Three Years to Pay Taxes on the Withdrawn Funds

As we mentioned, you get a break on paying taxes on your early withdrawn funds: You have three years to pay tax or to return the funds your plan to avoid paying that tax.

  • You can repay all of the early-withdrawal funds or a portion of them.
  • You must pay tax on the portion you don’t return to your retirement plan.
  • These repayment deposits are not considered contributions and do not count as a typical affect contribution into your plan.

Now, you don’t have to replenish your retirement plan, but it would be the prudent thing to do if you can. You may need funds to help you get through this difficult time today, but you also need adequate funds when you retire, too.

Things to Consider before Taking an Early Withdrawal from Your Retirement Plan

While taking an early withdrawal from your retirement plan may sound like a good idea, especially if you need the extra funds, it’s critical that you understand how doing so affects your plan’s overall performance. Remember, the earnings in your plan are growing on a tax-sheltered basis. While the remaining funds in your plan continue to enjoy that status, you’ll miss that tax-advantaged earning opportunity on the withdrawn funds.

Additionally, the more capital you have in your retirement plan, the more you have to invest. Over time, the balance of your account also has an opportunity to earn compound interest, which can play a big part in increasing your bottom-line savings. If you withdraw funds, that depletes not only the amount you can invest, but also impacts that interest-earning potential.

Alternatives to Taking Money from Your Retirement Plan

Today’s interest rates are at historical lows. So, there are few other options you should explore before deciding to take an early withdrawal from your hard-earned retirement savings.

Take out a personal loan. If you qualify, this could be a good strategy that allows you to keep your retirement savings intact.

If your home is paid off, you can look into a home equity line of credit (HELOC). Or if you have enough equity in your home if it isn’t paid off, you can possibly acquire a home equity loan. Whatever your situation is, there are more than a few options to help ease your financial burden if you’ve been impacted by COVID-19.

You should carefully consider each choice available to make the best decision for you during these troubled times.

 

The strategies discussed do contain risks such as loss of your home or loss of principal. The strategies may not be suitable for everyone and alternative options may be available.

Please refer to IRS guidelines for expanded distribution options and favorable tax treatment for qualified individuals under the CARES Act.