Did you borrow from your 401k, 403b or personal retirement accounts to help cover other essential expenses during the pandemic? It’s completely understandable, particularly if you ran into a bit of financial trouble during COVID-19. The Coronavirus Aid, Relief, and Economic Security (CARES) Act made it easier for you to take money from your nest egg early and without penalty.
Normally, borrowers would have to pay a 10% tax penalty if they pull from their 401k plans before retirement age, at 59 ½. However, the CARES Act waived that penalty in 2020 as long as the withdrawal was coronavirus-related. The CARES Act allowed savers to withdraw up to $100,000.
A Personal Capital survey indicates that nearly 33% of Americans have withdrawn or borrowed money from an IRA or 401k during the pandemic, and almost two-thirds used those retirement savings to cover basic living expenses.
If you’ve taken a coronavirus distribution, we’ll help you walk through your next steps.
Americans Pulled Money Out for Many Reasons
Take a look at the reasons individuals took money out of their retirement accounts, citing a hardship withdrawal.
Received a COVID-19 diagnosis: If individuals, their spouses or dependents were diagnosed by a test approved by the Centers for Disease Control and Prevention (CDC), they could qualify for a hardship withdrawal.
Experienced adverse financial consequences: As a result of being quarantined, being furloughed or laid off, or having work hours reduced due to COVID-19, Americans took money out of their retirement funds. In addition, those who experienced adverse financial consequences as a result of needing child care could qualify. Those who faced reduced hours of a business they operated could also take a hardship withdrawal. Americans also may not have had any other choice except to tap into retirement funds if they were at risk of eviction or foreclosure and didn’t have an emergency fund that could cover the full amount.
Other approved hardships: Home repairs after a disaster or medical expenses may also have been a reason Americans pulled money out of their retirement funds.
Whether you took money out for these reasons or another qualified hardship, you may wonder what you should do next.
What Should You Do Next?
Let’s go through a few tips, especially if you withdrew last year but didn’t do anything related to your withdrawal with your taxes.
Tip 1: Understand the difference between a withdrawal and loan.
The IRS defines a traditional withdrawal as having a financial need, such as in the case of having to pay for foreclosure on a home or medical expenses. You do not have to pay back a withdrawal from your 401k. In other years, you’d pay a 10% penalty as part of your withdrawal.
With a 401k loan, you borrow money from your retirement savings account. Normally, you could take out as much as 50% of your savings up to a maximum of $50,000 within a 12-month period.
You must pay that borrowed money back, plus interest, within 5 years of taking your loan. Unlike 401k withdrawals, you don’t have to pay taxes and penalties with a 401k loan. However, if you leave your current job, you risk having to repay your loan in full during a short timeframe. If you can’t pay it back, you must pay taxes and a 10% penalty if you’re under 59 ½.
Tip 2: Understand the tax implications.
Normally, you’d face major tax implications when you take out a loan from your 401k. You’d pay tax on the interest you pay back to yourself, then get taxed again when you withdraw during retirement.
The CARES Act allowed you to withdraw $100,000 from eligible retirement plans without incurring the usual 10% early withdrawal penalty.
As already mentioned, you don’t have to repay the funds, but if you do within three years and file amended returns, you won’t suffer a tax liability for your withdrawal. You will need to file amended tax returns for those prior years to show that the withdrawal was returned.
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Tip 3: Determine when to pay the money back.
At this point, if you’ve already taken a coronavirus-related distribution, you may wonder whether you should repay the money right away. You may also wonder when you should pay taxes on the distribution if you didn’t put the money back.
Normally, you would owe income tax on emergency withdrawals from 401ks and IRAs during the same tax year. However, the CARES ACT gives you three years to pay the tax bill. For example, let’s say you took a qualified $6,000 distribution in 2020. You could report $2,000 over the course of your 2020, 2021 and 2022 tax returns.
If you can pay back the full amount you took out within three years, you can claim a refund on those taxes.
Tip 4: Know that if you can’t repay within three years, you’ll owe taxes and penalties.
What happens if you can’t repay the money within three years?
You’ll owe taxes and possible penalties. In addition, you’ll also pay for it in more ways than one — including through a lack of long-term growth.
If your income has been substantially affected this year and the withdrawal doesn’t bump you into a higher tax bracket, it may make sense to recognize the distribution more rapidly when you’re being taxed at a lower rate.
Let’s say you have $40,000 in your 401k. Let’s say you also take a $10,000 coronavirus distribution. If you don’t pay it back, you’ll lose out on your tax refund and gains over time.
In this scenario, $40,000 could grow to over $67,000 with 8% returns after 40 years without additional contributions. On the other hand, $30,000 might only grow to about $50,000. This means that withdrawal could result in a loss of over $37,000 in the long term. Use Personal Capital’s retirement calculator to examine your specific situation and the effects it could have on your long-term wealth.
Tip 5: Make use of online financial tools.
Feeling lost about what you should do next? I recommend talking to a professional at Personal Capital to understand your options and the implications for taking money out of your retirement fund due to the CARES Act.
Consider Bill’s situation. (Though Bill did not take money from his accounts during the pandemic.) Like many people in this time, he was overwhelmed with retirement planning.
“There were several accounts that were set up: a 401k from a previous employer, my military retirement, and a couple of mutual fund accounts that were just sitting idle. No one was really managing them. Every once in a while, I’d take a look at it, but that was it,” he said in an unpaid testimonial. “So I hadn’t been managing my money at all.”
After working with Personal Capital, Bill has projected that he can comfortably retire. As a bonus, he has also talked his children through the financial steps he knows they need to take to secure their own financial futures.
“I talk to my advisor probably once a quarter,” said Bill. “And if I haven’t talked to him, then he’ll call me and say, ‘It’s time to review your plan.’” Bill checks his account about five times a week and likes being able to review his assets and ask questions.
“When we make a decision to purchase or do something, we don’t have to second-guess whether we’re making the right decision or not—at least from a financial perspective,” Bill said. “It’s a luxury not to have to question every purchase. I am very satisfied with the relationship we have with Personal Capital and the confidence that this has given us.”
Choose the Right Moves for Your Needs
If you’ve taken money out of your retirement investment accounts, you want to make the right moves now. A chief reason: You may need to effectively make up for any losses you’ve incurred when you took money out of your account. Ultimately, the quicker you repay the money, the quicker you can start earning more on your returns. Every dollar you take from your 401k or IRA today means less you’ll have in retirement, thanks to the miracle of compounding interest.
Moving forward, also know that you should only look at withdrawing money from your retirement accounts as a last resort. Hopefully, you only took out what’s absolutely necessary and will pay the amount back within three years — though the sooner you can pay it back, the better.
It’s your future — guard it well! Reach out to a Personal Capital advisor to help you navigate your situation. To get started, sign up for the free financial tools, aggregate your financial accounts, and see if you qualify for financial advisory services. Those who don’t qualify can still use the financial tools for free.
Personal Capital compensates Melissa Brock (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The client testimonial is representative of the client’s views at the time they were collected. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.