Using your 401(k) as an emergency savings account is risky.
Congress loosened the rules for taking money out of retirement accounts for those adversely affected by Covid-19, but even though the pandemic is still raging, there’s a deadline coming up for taking enhanced loans: It’s September 22. The deadline for taking 401(k) or IRA distributions under the special rules is December 31.
If you’re in a financial squeeze because of the coronavirus, tapping your retirement savings should be the last place you look to, after using up emergency savings. Still a lot of Americans are reaching into their retirement accounts.
Among the 401(k) and 403(b) workplace retirement plans that it administers, Fidelity Investments had processed just over 1 million CARES Act distributions through August, with more than a third of those in July and August. Enhanced loans aren’t as popular, but the number of Fidelity clients taking them is going up too. Fidelity found that 36,000 individuals had taken CARES loans through June. Another 33,000 Fidelity account holders took CARES loans in July and August, for a total of 69,000.
The CARES Act, passed in March in response to the Covid-19 pandemic, increases the amount you can borrow from your 401(k). For loans taken from March 27 through September 22, 2020, you can borrow 100% of your account balance up to $100,000 (less any outstanding loans). That’s up from the normal rules that allow you to borrow as much as 50% of your account balance up to a $50,000 limit.
Under the CARES Act, you also can take up to $100,000 as a distribution from a 401(k) or IRA in calendar year 2020, and the normal 10% early withdrawal penalty for folks under 59 1/2 is waived. You’ll still owe income taxes on the money you take out, but you’re allowed three years to pay the taxes. If your circumstances improve, the law says that you can redeposit the money you took out back into your retirement account (or another eligible retirement account) as a rollover contribution within three years.
Why aren’t more people taking enhanced loans? They might calculate they won’t be able to afford the required payments. And there’s this danger: If you leave your employer, a defaulted COVID-19-related loan would incur full income taxation plus the 10% early withdrawal penalty in the year of default.
Thinking about tapping your 401(k) or IRA? Here are some more warnings from experts.
Are you eligible? Your retirement plan will ask you to certify that you’re eligible. Valid reasons include having had Covid-19 or being laid off or unable to work due to child care, for example. The IRS expanded eligibility for 401(k) and IRA loans and distributions in June Covid-related guidance.
“It’s the individual certifying on their tax return that they’re eligible; they’re subjecting themselves to an IRS audit,” says Jeff Holdvogt, an employee benefits lawyer with McDermott Will & Emery in Chicago.
Watch out for fraudsters. Scammers are encouraging investors to take money out of their retirement accounts under the CARES rules not for current financial needs but to invest in high-risk, high-fee investments, according to an alert from the Securities & Exchange Commission, which includes factors to consider before borrowing against your retirement account to make new investments.
Consider the long-term. The Employee Benefit Research Council has found that using retirement plans as de facto emergency savings vehicles where workers are provided CARES-like access to withdrawals as various crises occur could be catastrophic, reducing retirement balances as a multiple of pay at age 65 by 54 percent. That said, EBRI also found limited reductions in projected retirement balances when employees pay back CARES distributions or take new loans.
The IRS has detailed guidance for coronavirus-related distributions and loans from retirement accounts in Notice 2020-50.
Further Reading:
Laid Off? Your Employer Might Owe You Unvested 401(k) Money
