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Don’t Poach That Egg!

Why the $100,000, penalty-free 401(k) withdrawal provision in the newly released stimulus bill might not be all it’s cracked up to be

By Cody McAlester | March 30, 2020

Cracked golden egg

In the wake of the economic shock caused by the coronavirus pandemic, Washington recently approved a package of stimulus measures, including one that allows savers to take emergency hardship withdrawals of up to $100,000 from their retirement plans.

But even in times of desperation, “could” doesn’t always equal “should.”

“Generally speaking, I am not in favor of draining retirement resources for a financial emergency, particularly if it is caused by a relatively permanent change in situation, such as the death of a breadwinner,” said Kim Bridges, director of financial planning at BOK Financial. “In some cases, it could be all for naught — succeeding in doing little more than delaying the inevitable and jeopardizing retirement in the process.”

Distribution considerations

The most glaring issue with taking a 401(k) withdrawal in a bear market is that you will likely be selling assets that have significantly declined in value. With broad market indices down roughly 30 percent year-to-date, locking in those losses and missing the inevitable market recovery could be devastating to your financial future.

On top of that, the amount you withdraw is further reduced by the required taxes due, which could include a 10 percent penalty, netting significantly less cash than anticipated. In the U.S., bankruptcy laws protect 401(k) balances. Though most assets are considered fair-game for settling debts in a chapter 7 bankruptcy, most retirement accounts are off-limits to creditors. But once you withdraw those funds for hardship, they are no longer protected.

In a worst-case scenario, you withdraw the funds to help in the short term but still have to file bankruptcy down the road. You’ve permanently lost your nest egg for nothing. Even if the withdrawal helps avoid bankruptcy altogether, leaving your future self with little to no retirement assets can mean a significant setback toward reaching your retirement goals.

CARES Act—mitigating some concerns

However, the CARES Act (Coronavirus Aid, Relief, and Economic Security Act), signed into law by President Trump on March 27, contains important features that make a “Coronavirus-related distribution” from an IRA or employer-sponsored retirement plan a reasonable option for some people. The Act allows individuals who are impacted by the virus to make such distributions penalty-free if they qualify. Qualification is based on personal financial impact resulting from the pandemic. There is a long and broad list of qualifying factors, and you will want to make sure you are eligible before implementing this strategy. For those whose current financial emergency is directly caused by the Coronavirus, and who would expect their financial situation to return to normal after the pandemic passes, this may be a viable strategy.

Along with waiving the usual penalty for early withdrawals, the Act removes the standard 20 percent mandatory withholding that generally applies to distributions and allows you to spread taxes on such distributions over three years. The Act also allows the distributions to be repaid, through full or partial rollovers, over a three year period. Because taxes and penalties will not reduce the distribution amount, you will receive the total amount of the distribution. Additionally, if you can roll the funds back into the account before the end of three years, the distribution may not permanently reduce your retirement account.

However, some existing concerns remain. Depending on the asset mix in your account, the distribution could still cause you to liquidate assets that have declined in value. If your repayment through rollovers occurs after the market recovers, you will have missed the recovery. If you choose to pursue a retirement plan distribution, you will want to work closely with your financial advisor to select the best holdings for liquidation to raise cash for the distribution. You should also work with your tax advisor to determine the best strategy for paying the income tax on the distributions. In some cases, it may be best to pay all of the tax in 2020 while in a potentially lower tax bracket, rather than spreading it out over three years.

A loan to yourself

Another alternative might be an increasingly popular feature in many retirement plans— a 401(k) loan. This employer-optional provision allows savers to borrow a portion of their account balance penalty-free and pay themselves back over a set period. But be forewarned— even that comes with some risk, especially with today’s record-high unemployment numbers.

“401(k) loans should only be used by those who feel certain of their continued employment,” said Bridges. “If you lose your job with an outstanding loan balance, that balance may become due immediately. Any balance that remains unpaid beyond 30 days is treated as a taxable distribution and will likely not have the 10 percent early withdrawal penalty waived.”

Although not all employer-sponsored plans allow loans, where loans are allowed, the CARES Act enhances loan provisions allowing for an increase in loan amounts as well as delaying loan payments for up to a year for loans taken out in 2020. Keep in mind that loans are not permitted from IRAs.

Ultimately, every situation is different, but consider all options before rushing to crack that nest egg. Retirement funds are for retirement. While today’s economic environment is undoubtedly challenging, don’t let a short-term crisis derail your long-term plan.