What to Consider Before Cashing Out Your 401(k) Due to COVID-19

Certain changes under this year’s Coronavirus Aid, Relief, and Economic Security (CARES) Act are allowing struggling individuals to withdraw from their 401(k) before 59½, without incurring the same penalties that they would’ve faced a year ago. For many people who are struggling through this economic crisis, these changes may look like the answer to all of their problems. But there are a few things to consider before cashing out that 401(k), even with the reduced penalties.

The CARES Act (which also provided the economic stimulus checks most of us received) effectively eliminated the early withdrawal penalty, for now. This penalty was 10% of the distribution, on top of automatic withholdings for taxes (20% or more) if you withdrew before you were 59½. These penalties were designed to strongly discourage people from pulling their retirement money too early.

But now that the $2 trillion economic relief act is in effect, early withdrawals look a little different. For your employer-sponsored retirement account (401(k) or 403(b)) or your personal retirement account (IRA), you can withdraw up to $100,000. The following changes have been made under the CARES act:

• You can withdraw from your retirement account without the original 10% penalty
• Mandatory withholding requirements are also waived
• Your distribution can be taxed as income divided equally over the 2020 - 2022 tax years
• If you can pay the money back before you hit the three-year mark, you’ll be able to claim a refund on those taxes
• If you’re pulling from a 401(k), you can pull 100% of your vested balance (the old limit was 50%) as a loan of up to $100,000
• You can delay payments on your loan for up to a year
• Required minimum distributions are waived

So, what requirements do you need to meet to take advantage of these benefits? You may think that you need to have had the coronavirus to qualify, but that’s not the case. The IRS describes the qualification requirements as anyone that’s seen “adverse financial consequences” due to COVID-19. This applies to your spouse and other members of your household, as well.

Adverse financial consequences might include a quarantine, furlough, or lay-off. If your hours have been cut at work, you’ve had a job offer delayed or withdrawn, your income was reduced, or you couldn’t work because you couldn’t find adequate childcare, you’ll also meet the requirements. As these qualifications also apply to your spouse, you may still be able to withdraw from your retirement account even though you’re still employed and don’t personally meet the requirements.

Reasons Not to Withdraw

You’ll have less later

Without the penalties of the past, pulling from your retirement account may seem like the easiest answer. But most financial experts still recommend avoiding it if you can. They recommend exhausting your other resources first, including your emergency fund or other forms of savings. Each early withdrawal you make now means less you can withdraw later, and less you will have for retirement. When you factor in compound interest, even small withdrawals can be significant. When you’re ready to retire, you’ll find that compound interest is your best friend.

You risk missing out on gains

If you pull money out of your investment account during a market fall, you’re essentially locking in your losses. When you reinvest later, it’ll likely be after the market rebound, and you’ll have missed out on the gains. Watching your investments drop can be scary, but the real loss doesn’t occur until you sell. Generally, it’s better to ride it out and wait for the rebound that will inevitably come.

The Bottom Line

With the changes under the CARES act, there are some instances where it makes sense to pull from your retirement money. Generally, this should be a last resort. But for many people that have been impacted by the economic collapse this year, that time may have come. A few instances that may make an early withdrawal worth it:

• It’ll save you from a major housing issue
• You need it to keep up with your bills
• You’ve run through (or don’t have) an emergency fund or other savings
• It’ll help you meet basic needs (medical care, prescriptions, food, etc.) 

Make sure to speak with your plan administrator or human resources department before you make your withdrawal as each company administered plan has a different policy and it’s own set of rules.