The COVID-19 pandemic has been more than a health crisis—it’s been a financial crisis as well. Business closures, job loss, reduced hours, and limited financial relief led to many savings accounts taking a major hit. As a result, more than 2 million Americans took advantage of the waived penalty for early withdrawal from a 401(k) or other qualifying account set forth in the CARES Act of 2020. This benefit may have been a financial life raft for some, but the move to tap into retirement funds isn’t without short- and long-term impact.
401(k) Early Withdrawal in 2020
Dipping into a retirement savings plan such as a 401(k) before age 59 ½ typically is not without penalty. However, in response to the ongoing COVID-19 crisis, the CARES Act of 2020 made it possible for retirement savers younger than 59 ½ to withdraw, for Covid-related reasons, up to $100,000 from qualified accounts without paying the usual 10% early-withdrawal penalty. For Americans who took a withdrawal, the money is yours and you don’t need to figure out a repayment plan. However, the flip side to this move is that retirement funds you’d planned to live on in the future are now diminished.
Taxes Upon Withdrawal Still Apply
The CARES Act temporarily eliminated the 10% early-withdrawal penalty, but the legislation didn’t pardon the taxes due. While you don’t generally pay taxes on contributions to traditional 401(k)s and IRAs, you do need to report income and pay taxes upon withdrawal. This holds true even though the CARES Act canceled the 10% early-withdrawal penalty for a short time. The temporary rules allow for the distribution to be spread across three years, but you need to account for a least one-third of the taxes due on that amount on your 2020 tax return.
Paying it Back is Recommended
Though you’re not required to pay back this type of withdrawal, experts agree that it’s generally in the saver’s best interest. Doing so allows you to avoid the taxes and to replenish your retirement account. If you pay back the full distribution amount within the three years, you can amend your tax returns and get all the money back paid in taxes.
For those who took a plan loan, you generally have five years to pay it back. You’ll need to be diligent in sticking to the plan’s repayment schedule. A loan that isn’t paid back could be counted as a distribution, therefore taxes (and possibly a penalty) will apply.
Savers who took a coronavirus-related distribution have more leeway in developing repayment strategies that best serve their personal situations. Those who took a plan loan have less flexibility, but some repayment strategies could be advantageous, including:
- A mortgage refinance. Given the current low interest rates, refinancing might save a few hundred dollars a month. That savings could then be redirected to repay the 401(k) funds.
- A home equity line of credit. Take advantage of low interest rates, with the ability to pay back the line of credit over at least 10 years.
- Student loans. For savers with college-age children, don’t count out the possibility of relying on federal student loans to help fund college costs while using the freed-up out-of-pocket cash to help pay back funds taken from a 401(k), perhaps in a lump sum. A federal undergraduate loan interest rate of 2.75% through June 30, 2021 combined with conventional thinking that you can borrow to pay for college make a potentially attractive avenue. Just be aware to not overborrow and dig yourself deeper into debt.
Some people may need to apply more than one strategy to return the money to their 401(k), relying on different options that will get them through the next few years. Work with a financial advisor to help determine the best path forward to getting back on track.