Three Ways to Tap Into Retirement Savings Early During a Financial Crisis

The COVID-19 Pandemic has wrought havoc on more than just the nation’s health. It has affected people’s finances as well. Congress anticipated this, and in March 2020, passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

Among the measures in the act are provisions allowing Americans easier access to the money they had been saving for retirement in accounts that ordinarily penalize early withdrawals. If you are in a position to need those funds now, you will want to know what taking a loan against a retirement account, or making an early withdrawal, could mean for you down the road.

In this blog post, we’ll talk about three options for tapping into your retirement savings early during a financial crisis, and what you should consider before doing so.

Retirement Plan Loans

Your workplace may offer a retirement plan that allows you to take a loan against it. Ordinarily, such loans let you borrow up to $50,000 or 50% of your vested balance in the plan, whichever is less. Typically, retirement plan loans have to be repaid within five years of taking the loan. You may be able to repay the loan over a longer period if you were using the funds to purchase your primary residence.

Under the CARES Act, employers can increase the amount of retirement plan loans to workers affected by the novel coronavirus to $100,000 or 100% of the employee’s vested balance in the plan, whichever is less.

Under the CARES Act, employers can increase the amount of retirement plan loans to workers affected by the novel coronavirus to $100,000 or 100% of the employee’s vested balance in the plan, whichever is less. This applies to loans made between March 27, 2020 and September 22, 2020. Also, plan participants who have an outstanding loan balance on or after March 27, 2020, are permitted to postpone any loan payments due in 2020 for one year.

Note that employers may increase the loan amounts available, but are not required to.

Penalty-Free Withdrawals from IRAs and Retirement Plans

As a general rule, making an early withdrawal from an Individual Retirement Account (IRA) subjects you to a hefty 10% penalty. There are some situations in which a penalty will not be imposed, including:

• Death or disability of the account owner
• Unreimbursed medical expenses which exceed 7.5% of adjusted gross income (this percentage goes up to 10% in 2021)
• A series of “substantially equal periodic payments” over your life expectancy or the joint life expectancy of you and your spouse
• The birth or adoption of a child, up to $5,000 per account owner
• Certain situations involving military reservists called to active duty
• Separation from service after age 55 (work-based plans only)
• Distributions required by a Qualified Domestic Relations Order (work-based plans only)
• First-time home purchase, up to $10,000 lifetime limit (IRAS only)
• Qualified higher education expenses (IRAs only)
• Payment of health insurance premiums in the event of a layoff (IRAs only)

Now, “coronavirus-related reasons” may join the list. (As with retirement plan loans, employers are not required to adopt these provisions.) These reasons include:

• The retirement account owner or certain family members being diagnosed with COVID-19
• A financial setback as a result of a quarantine, furlough, layoff, or reduced work hours
• Inability to work because the coronavirus made child care unavailable
• Business closures or reduced hours (for business owners).

Just because you can take an early withdrawal from an IRA or retirement plan without penalty, however, doesn’t mean you can take it without consequence. Obviously, the fact that you are withdrawing money from the account now means you will have less at retirement, so consult with your retirement planning professional to determine if an early withdrawal is the wisest way to meet your current financial needs.

There will also be tax consequences: distributions from a traditional IRA or work-based plan into which you made pre-tax contributions are considered income and must be reported on your income tax return. However, distribution income that is coronavirus-related can be reported over three years for tax purposes, unlike ordinary early distributions which must be reported in full for the tax year in which they are taken. Also, you have up to three years to reinvest the funds from a coronavirus-related distribution in the account.

Hardship Withdrawals from Work-Based Plans

People have always been able to make withdrawals from work-based retirement accounts such as 401(k)s in case of emergency. The IRS rules for these withdrawals require that the withdrawal:

• Be due to an immediate and heavy financial need;
• Be necessary to satisfy that need; and
• Not exceed the amount needed.

What qualifies as a financial hardship?

• Certain medical expenses for you, your spouse, or dependents (which could include COVID-19 care)
• Expenses to prevent an eviction or a foreclosure of your home
• Burial or funeral expenses for you, your spouse, or dependents
• Expenses to repair casualty losses from your home, such as from a fire, flood, hurricane, tornado or earthquake
• Up to 12 months’ worth of tuition and fees for you, a spouse or dependent
• Expenses to purchase a principal residence.

Bear in mind that hardship distributions are subject to the 10% penalty for early withdrawal, so you should probably consider this option only as a last resort.

If you have further questions about whether and how you should tap into your retirement savings during COVID-19 or any other crisis, please contact our law office to schedule a consultation.