WHAT IS THE CARES ACT?
The Coronavirus Aid, Relief, and Economic Security Act, more commonly know as the CARES Act, is a law intended to address the economic impact of the COVID-19 pandemic in the United States. The focus for this post will be on how the CARES act impacts withdrawals from 401K and IRA distributions. In addition to the obvious health concerns related to COVID-19, many Americans have been seriously financially affected. Perhaps you and/or your significant other have lost your job or taken a significant pay cut. As a result, you are exploring the option of taking money out of your retirement accounts. In some ways the CARES Act has eased the rules for taking money out of these accounts, but does that mean you should do it?
THINKING ABOUT TAKING MONEY OUT OF YOUR 401K OR IRA ACCOUNT?
Let’s talk about age. Typically, if you are under the age of 59 ½ and take money out of a retirement account, you would be subject to income tax plus an additional 10% penalty on the amount withdrawn. For example, if you were to take $10,000 out of your retirement account, the 10% penalty incurred would be $1000 plus the income tax charged based on your correlating tax bracket. With the CARES Act, the 10% penalty is being waived for eligible participants. However, that does not mean that these retirement withdrawals are free of consequence. If you are able to put back whatever money you took out within a 3-year time frame, then you ultimately do not have to pay income tax on it. However, if you are not able to put the money back within 3 years, you will have to pay income tax on it. If you’re able to do so, you can pay the income tax in the same year or spread it over the course of a 3 year period, to ease the financial burden. Now, if you are going to be in a lower tax bracket this year because of job loss or reduced income, it would be beneficial for you to pay the income tax all at once this year to save yourself money in the long run. If you’ve already rebounded and are working again and receiving your full pay, it may make more sense for you to pay the income tax over a 3-year period as your tax bracket will be higher. This is where the knowledge and experience of a Certified Financial Planner ™ professional would be very helpful to you, as he/she can evaluate your personal circumstances and help devise a customized strategy.
WHAT IF YOUR MONEY HAS BEEN INVESTED IN THE STOCK MARKET?
It is very likely that your 401k and IRA funds have been invested in the stock market. Depending on when you are reading this blog post and listening to the corresponding podcast, it is likely that your investments have decreased in value. So, by taking money out of one of these accounts, you are selling an already depleted asset which is not ideal. Essentially, you’ll be hit with a double whammy…you lose money by selling a depleted asset, and will then have to pay income tax on the amount you’ve withdrawn from the account (if it is not paid back within 3 years). Now if you can leave these investments in your 401K and IRA, the beauty of compound interest will start to show. Let’s say you have an $80,000 balance in your 401K and plan on retiring in 25 years, and you don’t add any more money to the balance. At an interest rate of 6%, your $80,000 could grow to $343,000 over the next 25 years. What if you’ve been financially impacted due to COVID-19 and withdraw $10,000 from your $80,000 balance? You’re now left with $70,000 in your 401K, and as in the previous scenario, you retire in 25 years and don’t add any more money to the balance. With that same 6% interest rate, you’re now looking at only about $300,000 in your 401K when it’s time to retire. So, by taking out just $10,000, you essentially lost about $43,000 over the course of those 25 years due to compound interest.
HOW ABOUT YOUR EMERGENCY SAVINGS?
In an ideal world, you have an emergency savings that will cover you during any economic hardship you encounter, and will not need to dip into your 401K or IRA, but this is often not the case. If you’ve explored all other options, including a Roth IRA (which uses after-tax dollars), and have no other choice other than to take money from your 401K or IRA, then that is of course understandable. I’ll reiterate again how imperative it is that you speak with a Certified Financial Planner ™ professional to help you navigate through all of this. Even if you must go off course temporarily with your financial goals, a Certified Financial Planner ™ professional can develop a plan to get you back on track, and possibly fully recover from the setback.
WHO IS ELIGIBLE?
Not everyone is eligible for the 10% tax penalty relief. At this time, the CARES Act provides this assistance for those who have been quarantined, furloughed, or laid off. By quarantined, I mean that you physically are unable to get to your job and as a result you are not receiving your income. Now, if you are quarantined but still able to work from home and receive your pay, you would not be considered eligible. If your job and income has not been directly impacted, but your spouse has lost his/her job due to COVID-19, you may be eligible for this tax break. What if you have your own business? If COVID-19 has negatively impacted your business, you may also qualify for assistance from the CARES Act. What about childcare? If your job and income have not been impacted by COVID-19, but the care for your child has which prevents you from working as you normally would, you may also be eligible for assistance from the CARES Act.
With the 401K loans, you are now able to borrow 100% of your vested balance. This money does have to be paid back, but generally without taxation. Typically, you can pay the money back through your paycheck. You can delay payment for 1 year, and then you have 5 years to pay the loan back. Now if you take out a 401K loan and you lose your job, you are required to pay all of the money back at some point. If you’re unable to do so, the unpaid money will become a taxable event plus the 10% penalty.
WHERE TO GO FROM HERE?
Listen to the On My Way To Wealth Podcast for additional information and specific examples related to the CARES Act impact on 401K and IRA withdrawals. Consult with a Certified Financial Planner™ professional as he/she can provide you with the knowledge and expertise critical to achieving your financial goals.
As always, thank you for checking out my podcast and blog post! If there are any topics you would like to learn more about, or if you would like to schedule a free financial consultation with me, please email me at Luis@onmywaytowealth.com! All of my podcast episodes can be found at www.onmywaytowealth.com and on all major podcasting platforms. For my business site, please be sure to check out www.buildabetterfinancialfuture.com. I look forward to helping you Build A Better Financial Future!