Many Americans are struggling right now as a result of COVID-19 and the great lockdown necessitated to slow its spread. The Coronavirus Aid, Relief, and Economic Security Act (or CARES Act) was passed to help those who are hurting financially. One way it does that is to make it easier to access money in 401(k) plans.
Taking money from your retirement accounts should always be a last resort; doing so jeopardizes your future financial security. But if you do need to tap these funds, a loan is normally preferable to a withdrawal for a number of reasons.
Because of the way the CARES Act changed the rules, however, you may be better off making a withdrawal rather than taking a loan for the time being. Here's why.
The downsides of withdrawals have been eliminated
Under normal circumstances, withdrawing money from a 401(k) generally triggers a 10% early withdrawal penalty if you're not yet 59 1/2. You're also subject to ordinary income tax on withdrawn funds in the year you take the money out.
The CARES Act changed the rules for hardship withdrawals necessitated by COVID-19. If you or a loved one have the virus or suffer a loss of income due to it, you can take out up to $100,000 without incurring the 10% penalty. You can also take up to three years to pay the taxes due on your withdrawal.
Most importantly, the CARES Act allows you to recontribute the money you've withdrawn over three years, without affecting your future contribution limits. You can put the money back by making payments over time or in a lump sum.
With this rule change, the CARES Act essentially enables you to borrow from your 401(k). And you can pay back the money on your own schedule instead of being required to follow a set schedule while paying yourself interest -- which you'd have to do if you took a 401(k) loan.
Loans are a riskier proposition
The CARES Act also changed the rules for 401(k) loans. You can temporarily borrow up to $100,000 or 100% of your vested balance, whichever is less. That's up from $50,000 or 50% of the amount vested. And while loans normally must be paid back over five years, the CARES Act allows repayment to be extended to six years.
But there are two huge risks you face:
- If you lose your job, you could be forced to repay the loan by tax day in the year that follows the job loss, leaving you much less time to pay back what you owe.
- If you default on repayment (either on the standard repayment plan or because of a job loss), it will be treated as a withdrawal and you'll owe taxes.
The CARES Act doesn't explicitly convert a default on a 401(k) loan into a penalty-free withdrawal, even though you could have taken up to a $100,000 penalty-free coronavirus hardship withdrawal this year.
So while a loan could theoretically be a better choice because you're obligated to pay back the money, and you have more time to repay the money, and the interest you pay helps ensure you don't lose as much ground in your retirement savings, nonetheless you're taking a big gamble that you'll be able to pay back what you borrowed.
What should you do?
Before taking a loan or withdrawal from your 401(k), explore all other options.
If you feel you have to access your retirement funds, it's important to weigh the risks of a loan carefully. If there's a chance you could default on your payment for any reason, you may be better off taking a withdrawal so you don't risk a 10% penalty.
If you do take a withdrawal, though, aim to put the money back within the three-year deadline for recontributing so you don't set your retirement savings back. And the sooner you can get your money invested again, the more likely it is you'll be able to take advantage of any coronavirus market recovery and see your investment account balance rise.