Which is better if you have no other choice – a 401(k) loan or 401(k) hardship withdrawal? (part 3 of 3)
May 29, 2020 | by David Weis, MBA, CFS* Financial Advisor at Arsenal Credit Union
If you’ve taken an inventory of what you have and determined your only choice is to access your retirement accounts, let’s review the options under the CARES Act.
These qualify under the CARES Act. Your plan may or may not allow loans under this legislation; it is up to your plan administrator.
To qualify under the CARES Act, either you or your spouse or a dependent have been diagnosed with the coronavirus (COVID-19) or financially impacted in any number of ways, including furloughed, laid off, etc., or you have experienced a financial hardship as a result of quarantine.
The 401(k) loan option is better than a withdrawal. The reason: you will receive more net dollars. It’s not considered a taxable event (no federal or state taxes) if you take the loan and pay it back over the allowed time frame. You are borrowing from yourself. If you leave employment under the plan, however, the loan changes from a tax-free loan to a taxable withdrawal from the 401(k) plan. In such case, you will owe federal and state taxes unless you pay back what you borrowed under the terms of the loan – usually within 90 days.
Before the current pandemic, when a 401(k) plan allowed loans, you could only borrow up to 50 percent of your vested balance, and the absolute maximum you could borrow from it was $50,000. What changed under the CARES Act is that (if your plan administrator allows changes to the plan) the 50 percent limit on vested balances is removed, the maximum amount is now up to $100,000 of your vested balance, and you can repay that borrowed amount in 2020, 2021, and 2022 – giving you more time. You can elect to have the distribution either not taxed subject to it being repaid within three years or taxed ratably over a three-year period.
Already have a 401(k) loan?
Sec. 2202(b) also provides qualified participants with loans in effect on or after the CARES Act enactment date of March 27, 2020, that would otherwise be due between March 27, 2020, and December 31, 2020, to suspend their loan repayment obligations for one year, akin to the rules involving suspensions for military leaves or unpaid leaves of absence. The interest continues to accrue during the suspension period, and the statutorily allowed maximum of five years for repayment does not include the year of suspension.
401(k) 403(b) 457(b) IRA withdrawals/distributions
Due to COVID-19, withdrawals/distributions from your retirement account under the CARES Act qualify for some special treatment.
Before COVID-19 and the CARES Act, withdrawals/distributions of vested balances had a 10 percent early withdrawal penalty assessed plus a tax penalty for those under age 59½ in the year it was taken.
If you can, there are provisions to repay withdrawals/distributions back into an IRA, 401(k) or other type of plan. Ask me how I can help advise you on different repayment provisions.
The coronavirus-related distribution provision offers a whole variety of benefits for individuals who have been impacted. If you are under age 59½ at the time of the distribution, it will be exempt from the early withdrawal penalty of 10 percent. The maximum withdrawal amount of up to $100,000 of vested balances are now allowed. Tax consequences for withdrawals/distributions will generally be spread over three years, so 2020, 2021 and 2022 equally. Seek professional tax advice on this decision – neither I nor CFS* provide tax advice.
Be careful to consider the tax consequences of whether you want to spread it out over the three years or take it all this year.
If you’re having a really bad income year due to being laid off, furloughed or let go, your income may be down to the point where you may want to elect to record all your withdrawals this year.
Re-pay that withdrawal if you can. The coronavirus-related distribution provision extends that repay time frame to a three-year period following the date you received the distribution, including 2020, 2021 and 2022.
When it comes down to it, you may not have a choice, but pulling money out of your retirement accounts will have some serious future consequences. Specifically, lower retirement account balances will generate less income from savings, may require you to work longer than planned in order to catch up some of the loss savings and earnings, and may result in further sacrifices in living style in retirement.
About the Author
For more than 12 years, David Weis has helped his clients develop, implement and monitor personalized financial plans. He specializes in retirement strategies and IRA rollovers for 401(k)s, 403(b)s, 457s, Profit Sharing, and TSPs. Learn more by visiting his website, or call 314.919.1058 or send an email to reach him.
*Non-deposit investment products and services are offered through CUSO Financial Services, L.P. (“CFS”), a registered broker-dealer (Member FINRA / SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. The Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.