Should You Withdraw $100k From Your 401k Penalty-Free?

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), passed back in March, allows individuals affected by COVID-19 to cash out up to $100,000 from their 401(k) without facing the 10% early withdrawal penalty. But should you withdraw $100k from your 401(k)? In this article, I unpack everything you need to know.

Understand the Terms

Let's look at the rules for cashing out from your retirement savings under normal circumstances.

It’s typically possible to withdraw money from your 401(k) before the age of 59.5. However, this early withdrawal comes with penalties--these end up costing a substantial amount from what you would get after retirement. The penalty for cashing out before the age of 59.5 is usually 10% of the total distribution and an additional withholding of not less than 20% for taxes.

In the CARES Act, the government relaxed these terms. The stimulus bill allows those affected by COVID-19 to access their retirement funds with fewer penalties. This forgiveness means you can withdraw up to $100,000 from employer-sponsored retirement accounts--401(k)s and 403(b)s--and others such as traditional individual retirement accounts.

There are several provisions included in the CARES Act:

There will be no 10% penalty for distributions made in 2020.
The distribution will be taxable as income for the years 2020, 2021, and 2022. Individuals, however, will get a refund on those taxes if they manage to repay the amount cashed out within the three years.
You can cash out 100% of your retirement savings up to $100,000. This loan won’t attract any interest for the next year. The loan is different from the previous borrowing, which limited borrowers to 50% of their retirement savings.

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To access this distribution, you must prove the coronavirus has affected you directly. Being 'affected' means that you, your dependents, or your spouse has received a diagnosis of COVID-19.

Besides those affected directly, this relief also caters to the following groups:

People forced to stay home and care for their kids
Business people who have had to shut down due to the pandemic
Individuals who can no longer work because they are under quarantine
Individuals furloughed or laid off due to the outbreak

Why You Should Proceed with Caution

While cashing out your 401(k) might seem like a perfect source of money during this challenging time, don’t celebrate too early. There are many things to consider before withdrawing your retirement savings.

The Impact on Your Retirement Benefits

Taking money from your retirement account means you will be reducing your retirement benefits. Due to compounding interest, you will be losing a lot if you are unable to pay back the amount you take from your 401(k).

For instance, let’s assume you have $60,000 in your 401(k) and decide to take $6,000 with no penalty. If you are unable to pay back the amount within three years, you will lose substantial long-term growth and a tax refund. In the next 20 years or so, you would have lost more than three times the amount cashed out in terms of interest.

If you didn't cash out the $6,000 from your account, your total amount could grow with a more significant margin. Now, some people have no choice but to cash out some amount in their 401(k). If you do, try to pay it back within three years.

You Will Still Pay Income Tax

As explained earlier, the amount you withdraw is taxable income. However, you'll receive a three-year duration to repay the distribution. If you pay back the amount within this period, you'll be eligible to file for a tax refund.

It's a Bad Investment Decision

If you decide to withdraw money from your retirement plan during this economic crisis, it will be the wrong timing. Stock prices have plummeted over the past few months, which means you will be locking in the losses you've already incurred.

There's No Guarantee Your Employer Will Approve the Distribution

Although the government has allowed employees to apply for hardship distributions, there is no obligation for employers to approve it. Individuals have to talk to their human resource departments before making any withdrawals.

The terms for withdrawing money from your 401(k) might require evidence to show you have exhausted all other sources. Therefore, there's not a 100% guarantee that your employer will allow you to access the funds.

What's the Difference Between 401(k) Loans and 401(k) Distributions?

With the new rules in place, there are clear-cut differences between 401(k) loans and distributions.

If You Decide to Cash Out

You do not need to repay the amount
No 10% withdrawal penalty
The amount is taxable income, but you are eligible to claim a tax refund if you pay it back within three years

If You Opt for a Loan

There's a specific repayment period, usually five years
The amount is not subject to tax or a 10% early withdrawal penalty unless you are unable to repay within the specified period.
Borrowers with loan payments due in 2020 get up to one year of no interest on their loans.

Use Your 401(k) Savings as a Last Resort

From the above deductions, it's clear that taking money from your 401(k) could be a bad move in the long run. However, if you have exhausted all your options, you could use this funding to get out of a hard economic situation.

There are several instances when youre better off using your 401(k) distribution. These include:

Protecting Yourself Against High-Interest Debts

There are instances when you can opt to use a high-interest personal loan or credit card. However, based on the high interest charged on these funds, it might make more sense to use cash from your retirement account. The new terms of repaying the amount within three years and the possibility of getting a tax refund are enticing.

Catering for Basic Needs

If you are in a desperate situation where you can't afford basic needs for you and your family, it's more reasonable to use your retirement money. You can use this money to pay for essential food, prescriptions, elder care, or medical emergencies.

Pay for Housing

Most landlords or financial lending institutions are offering some mortgage or rent relief during the COVID-19 pandemic. However, this isn’t being applied equally.

If your lender or landlord is not willing to consider your situation, you might be staring at a possible eviction or foreclosure. In this case, it's more reasonable to use your 401(k) distribution to settle housing expenses.

What Are the Alternatives?

The purpose of retirement savings is to cater for the later years when you won't be in a position to work. If you decide to cash out before that time comes, make sure you are in a place to pay it back.

The new CARES Act can help cushion Americans for the current economic hardships brought by the coronavirus pandemic. However, it should be a last resort. Before you decide to use this distribution, here are other alternatives you should consider.

Life Insurance

Life insurance offers many options to access emergency cash:

You can cash out
You can surrender your policy
You can take a loan against the policy or sell it in a life settlement

Many options make life insurance an excellent alternative in times of financial crisis. There are life insurance policies that come with built-in savings accounts, which accumulate cash value from the premiums over time.

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Home Equity Line of Credit (HELOC)

If you have a HELOC, you can borrow against the equity of your home. Your house acts as collateral for the loan. This option gives you a more extended repayment period of up to 20 years. It also allows you to borrow up to 85% of your home's value minus what you owe.

Emergency Fund

For those who hold an emergency account, this is the time to make use of it. An emergency fund acts as a financial safety net for difficult times like the one we are facing now.

If you are just starting to build your emergency fund, I’d stick with a high interest savings account. Once you’ve built up a cushion, you can look to get some higher rates with CDs.

Bottom Line

The government’s measures are a welcome move that is likely to cushion some Americans from the economic effects of COVID-19. However, you should use your retirement money as a last resort. If you have to withdraw any amount, have everything planned out to avoid defaulting on the repayment. Only take what is necessary and try as much as you can to repay within three years. This method will help you to retain your benefits and, most likely, get a tax refund.