Think Twice before Making a 401(k) Withdrawal Right Now
If you’re thinking about making a 401(k) withdrawal right now to help make ends meet or have extra cash on hand, you’re not alone.
In fact. According to MassMutual, 55% of Americans are rethinking their retirement savings plans.¹
Before you touch your 401(k), we encourage you to think twice and educate yourself on the possible consequences of doing so.
Keep reading to find out the difference between a loan and a withdrawal, and 4 reasons withdrawing from your 401(k) right now might be more detrimental to your financial future than you realize.
401(k) Loan Versus 401(k) Withdrawal
There is a huge difference between a 401(k) loan and a withdrawal. Put in the simplest terms…
🠞 A 401(k) loan you have to pay back. It is not a distribution.
🠞 A 401(k) withdrawal you don’t have to pay back.
In response to the economic fallout of COVID-19, the CARES Act loosened restrictions on both loans and withdrawals. So, let’s take a quick look at the new rules surrounding each.
401(k) Loans
Under IRS guidelines, you can borrow up to $50,000 or 50% of your vested account balance, whichever is less.
When you take out a 401(k) loan, you are borrowing the money from yourself and paying yourself back–but with interest.
However, the CARES Act doubles the borrowing limit on your 401(k) from $50,000, or 50% of the vested account balance, up to $100,000, or 100% of your vested account balance.
This provision allows qualified participants to take a loan from a qualified employer plan between the bill’s date of enactment, March 27, 2020, and September 23, 2020. You can also delay payments on the loan for up to a year–however, interest will accrue.
Under the legislation, you are supposed to show hardship as a result of COVID-19, but this is a self-certification process, so you might not need to prove much.
Be aware that each plan administrator will treat this differently and some may require more documentation than others.
In addition, some employers do not allow you to take out a 401(k) loan at all.
401(k) Withdrawal
Pre-COVID-19 and the CARES Act, if you wanted to withdraw from or cash out your 401(k), you needed to be at least 59½ years old without paying early withdrawal penalties to the IRS.
These withdrawals are subject to ordinary income tax on the amount you withdraw plus a 10% early withdrawal penalty–unless you qualify for a hardship withdrawal.
As previously mentioned, the CARES Act changes the hardship withdrawal definition and lessens some of the penalties and taxes that come from taking money out of your 401(k) before you are of age.
If you qualify for a Coronavirus-Related Distribution (CRD) from your 401(k) plan any time during 2020, that distribution will be treated as a safe-harbor distribution.
This means it will not be subject to a 10% early withdrawal penalty if you are under 59½. However, it will be subject to regular income taxes, which you can spread out over three years.
You are allowed to withdraw up to $100,000 of your account balance.
Should you pay back the money into your 401(k) account within 3 years, it will be considered a rollover, and not be subject to taxes.
#1 A 401(k) Withdrawal May Hurt Your Future Retirement
The advantage of using a 401(k) to grow your retirement savings is that you can grow your nest egg tax-deferred.
You contribute consistently and more year over year and your money grows…and grows. That’s the power of compounding.
Ideally, you wouldn’t take a withdrawal until you retire.
But we are living in strange times.
While we understand you may need money to pay the bills right now, we recommend withdrawing from your 401(k) as your last option.
According to the Center for Retirement Research at Boston College, early withdrawals reduce overall 401(k) assets for retirement by 25% on average.²
Research conducted by Employee Benefit Adviser shows, “A hypothetical 30-year-old participant who cashes out a 401(k) savings balance of $5,000 today would forfeit up to $52,000 in earnings the sum would have accrued for them by age 65, if we assume the account would have grown by 7% per annum.”³
Related Article: What Should I Do with My 401(k) Right Now?
#2 You May Lose More Money Withdrawing Right Now
One of the worst times to withdraw is when the market is down.
Remember, you don’t lose money when the market is down–that is, unless you cash out at the bottom.
Taking a 401(k) withdrawal when the market is low means you have to withdraw a larger percentage of your account.
Related Article: 3 401(k) Mistakes Investors May Not Realize They’re Making Right Now
#3 You Aren’t Immune to Taxes
Should you qualify for the COVID-19 hardship and withdraw from your 401(k), you will still owe ordinary income tax on the money you take out.
Under the CARES Act, you will be able to spread out income taxes over the next 3 years to avoid a massive tax bill next year.
The last thing you want to do is get cash for the short term, only to find out it’s bumped you up to the next tax bracket.
Therefore, we recommend you speak with your CPA or tax professional to find out the real cost of cashing out.
Related Article: Important IRS Changes: Tax Relief for Americans during the Pandemic
#4 Your 401(k) Withdrawal Is Not Immediate
If you’re in need of cash–fast–you should know that it can take several weeks to get your money from your 401(k).
The reason for this is that each plan has a different set of rules it must follow before they can get you your money.
So, if you’re looking for a quick cash injection, withdrawing from your 401(k) isn’t going to help you in the short term.
Related Article: 7 Tips on How to Manage Your Finances Right Now
Your Next Steps
Before you touch your 401(k), we recommend you speak with a third-party expert who can help you make the best decisions possible–for right now and the future.
If you are financially hurting right now or uncertain about your financial future, please do not wait to speak to an expert about your situation.
401(k) Maneuver is committed to providing you resources to help you make the best possible decisions about your financial and retirement future.
We encourage you to check out our no-cost 401(k) Investing Masterclass.
In just 13 minutes, you’ll discover 3 strategies that may…
- Improve Your Account Performance – So you can have more money, creating a fulfilling retirement.
- Manage Risk to Minimize Losses during the Bad Markets – So you can keep more of what you have made.
- Reduce Fees That Harm Account Performance – So more of your investment grows for your retirement.
This Masterclass could change the direction of your retirement future. Click here for immediate access!
Sources:
- https://www.massmutual.com/about-us/news-and-press-releases
- http://crr.bc.edu/wp-content/uploads/2015/01/IB_15-2.pdf
- https://www.employeebenefitadviser.com/opinion/to-show-participants-you-care-help-them-avoid-401k-cash-outs
