The New Rules of Withdrawing From Your Retirement Account

The stimulus bill makes it easier for some folks to take early 401(k) and IRA distributions, but doing so can be risky. 

by Daniel Kurt

If Covid-19 has put the squeeze on your family’s finances, at least you’re in good company. According to a newly released NerdWallet survey, 69 percent of Americans report that their household income has taken a hit in recent months. That number jumps to 80 percent for Millennials and those in Gen Z.

As a result of the pandemic, millions of parents are suddenly struggling just to pay their mortgage or utility bills on time. For those who have already churned through their stimulus check and savings, the last refuge is withdrawing from their 401k plans and other retirement accounts to keep the lights on.

For better or worse, Congress has made that option a lot easier. Tucked inside the CARES Act are a set of provisions that allow for penalty-free early withdrawals from IRAs and workplace plans, as well as an increased cap on 401(k) loan amounts for those impacted by the virus.

Raiding your nest egg might seem like a better option than, say, racking up enormous credit card bills. It also comes with some serious pitfalls. Before tapping money that’s earmarked for your golden years, financial professionals say it’s important to think through the implications.

New Rules for Withdrawals, 401(k) Loans

In normal times, Uncle Sam does everything short of using a padlock to keep you from tapping into your tax-advantaged retirement accounts early. Want to make an early withdrawal from your IRA or workplace plan before age 59½? You usually face a steep 10-percent early withdrawal penalty — plus you have to fork over income taxes on anything you pull out (though with Roth accounts you only pay taxes on your gains).

If you’ve been medically or financially impacted by the pandemic, those guardrails are temporarily lifted. For the remainder of 2020, they can withdraw up to $100,000 from their retirement plan, absolutely penalty-free.

The law also takes some of the sting out of your tax bill by allowing you to evenly spread your distribution over a three-year period. So if you, for instance, take out $15,000 from your IRA, then you have the option to report $5,000 of income in each year from 2020 to 2022 (or, you can report all of it in 2020).

Now, if you end up repaying that withdrawal within three years — an option some, but not all, plans allow — you can also recoup whatever income taxes you’ve incurred. An individual who repaid his distribution in 2022, for example, could file an amended return to recapture the applicable taxes from 2020 and 2021, notes John Weninger, an Appleton, Wisconsin-based advisor with Endowment Wealth Management.

These temporary rules only apply to “qualified individuals,” however. That term may sound a bit nebulous, but it means that:

  • You, your spouse or dependent of yours has tested positive for the SARS-CoV-2, or the disease that it causes, COVID-19, through a CDC-approved test;
  • You experienced negative financial consequences from being laid off, furloughed, quarantined—or if your hours have been cut back;
  • You’re a business owner that has had to shut operations or reduce hours due to the pandemic; or
  • You can’t return to work because you’re having trouble finding child care.

Those who meet one of these criteria also have more leeway when it comes to taking loans from their employer’s plan, provided that your place of work allows them.

Under the stimulus bill, the existing limits on such loans have been doubled. Whereas in most years you can borrow the lesser of $50,000 or half your vested balance — i.e. the sum of your contributions and rollover amounts, plus any vested matching funds — qualified individuals can take out $100,000 or 100 percent of your vested balance until September 22. It also allows plans to delay repayment for up to a year on such loans.

Retirement Withdrawal: Short-Term Relief, Long-Term Consequences

In the financial planning world, money in a retirement plan is treated with the sort of reverence usually reserved for saintly relics. But if you’re in jeopardy of an eviction notice being slapped on your door, is it okay to toss the old rulebook to the curb?

Despite the relaxed rules, Weninger contends that early distributions should be a last resort. “There are downsides, chiefly that you’re missing out on the tax-deferred growth you would have had on the amount you withdraw,” he says. If you can’t repay the withdrawal, Weninger says, you also miss out on all future tax-deferred growth (or tax-free growth, in the case of Roth accounts).

Loans from a workplace plan theoretically sidestep that problem by forcing you to bring your account back to square. But depending on the size of your loan, repaying your account over the required time period — typically five years — can be a huge drag on your future budget. And if you leave your employer, says Weninger, you have to cough up the remaining balance much quicker.

Before raiding your retirement account, you should first exhaust other ways of shoring up your finances, says Dave O’Brien, co-founder of Richmond, Virginia-based planning firm EVOadvisers. That includes making use of temporary forbearance protections for federal student borrowers under the CARES Act and talking to your mortgage lender and credit card company, some of which are allowing interest-free deferred payments.

O’Brien also recommends taking a hard look at your expenses. If you can sell that extra car or pare down your guitar collection to make ends meet, it’s a lot better than putting your entire retirement in jeopardy.

Those in particularly dire straits may want to jettison non-essential payroll deductions as well. “This may be a time to significantly reduce contributions to their retirement plan, or even stop making contributions, even at the cost of foregoing an employer’s matching contributions,” says O’Brien.

Desperate times sometimes do call for desperate measures. But don’t think “penalty-free” means consequence-free when it comes to early retirement plan distributions. If there’s a way to keep your 401(k) or IRA intact by cutting your expenses or getting a side hustle, experts say you’ll probably be far better off.