Jeran Van Alfen, CFP®
What to know before taking a 401(k) Withdrawal (Updated with CARES Act Provisions)
Updated: May 16, 2020
One roadblock that I often see to retirement planning is spending your nest egg before you get there. You do a good job saving your money every paycheck, building up your 401(k), and then life happens. Whether it is a change in employment, debts starting to add up, or you are tired of being patient for that home remodel, the withdrawal options on your retirement account start to become tempting. With the current recession that we are in and many people dealing with unemployment, access to your 401(k) has become even more attractive, and for some people, it may be essential. Before you withdraw your retirement money, it is important to understand what options you have and to plan ahead for staying on track for your retirement goals.
A brief history lesson: Your grandparents didn’t have a 401(k)
The old retirement was different than it is today. People used to work for the same company for most of their careers. As part of the compensation package, companies would contribute money to a pension fund (defined benefit plan) instead of worker’s saving their own money in a 401(k) (defined contribution plan). When it was time to retire, the company would send the worker off with a paycheck for the rest of their life. There weren’t as many decisions to make when it came to retirement because for most people, their retirement income was fairly predictable.
Around 1980 the 401(k) was introduced and companies quickly began adopting the new company retirement plans. This was a way for the company to save money. The worker would now be responsible for choosing how much of their money to save and how to invest. Unlike pensions, the 401(k) also provides early access to money if you need it. However, since your retirement paycheck is up to you, withdrawing 401(k) funds early is essentially robbing from your future self.
Let’s let those guys handle it
There is a great scene in the show, “How I Met Your Mother”, where the characters Marshall and Ted are zoning out playing video games and have a conversation about who will get their shared apartment when Marshall gets married. Ted says, “That’s a tough one…you know who I think could handle a problem like that…Future Ted and Future Marshall.” Marshall replies, “Totally…Let’s let those guys handle it.”
This always cracks me up and it reminds me of the way most of us deal with retirement. We have so many current responsibilities, our future selves can handle the retirement problem. However, the more we push decisions off, the bigger challenges they become. For most of us to retire with a reasonable nest egg, it requires deciding to save early and then constantly re-visiting that decision by increasing our savings regularly. When we withdraw retirement savings early, we are sabotaging our chances for that money to grow to where we need it to be and we cause more problems for our future selves to solve.
Sometimes you need the money
You should look for other sources of funds first before considering your 401(k), but sometimes you need the money. Here is some information to know when choosing to make a withdrawal:
The important age to remember is 59 ½. This is the age that determines when you can withdraw money from retirement accounts without an IRS penalty. Anything before this age is considered an early withdrawal. Typically, early withdrawals will be assessed a 10% penalty tax by the IRS. There are exceptions that are discussed below.
Another important factor is whether you still work at the company or not. Most companies do not allow you to take an in-service withdrawal before age 59 ½ unless you are experiencing certain hardships.
Here are some options:
Rules vary depending on your company but most 401(k) plans allow you to borrow up to $50,000 or half of your balance whichever is lower. The terms of the loan typically require you to pay back the loan over 5 years and the interest rate is typically prime rate plus 1%. The Prime Rate for the week of 5/12/2020 is 3.25%
Advantages of a 401(k) loan:
Loan proceeds are received tax-free
No credit check required. Access to a 401(k) loan has nothing to do with your status as a creditor. It is purely determined by the plan rules.
The interest rate is typically lower than credit cards
Payments are automated. When you take the loan, payments are automatically scheduled to be taken out of your paycheck.
Disadvantages of a 401(k) loan:
When you take a loan, you will give up future earnings that the money could have earned if it stayed invested. These earnings can’t be made up. In order to determine how much the loan may cost you in earnings, you can use this Retirement Plan Loan Calculator from Vanguard.
If you leave the company while you still have a loan balance, this money will be treated as an early withdrawal. You will owe taxes on the amount as ordinary income received and if you are under age 59 ½ you will owe the 10% penalty.
Your interest is paid back with after-tax dollars. If your 401(k) loan is small or short-term then the interest that you pay may not be concerning. However, if you take a sizeable 401(k) loan and pay it back over an extended period, the interest that you pay will come out of your paycheck after Federal taxes. When you retire in the future, that interest that you paid back will be taxed again when it is withdrawn. It may be a small amount, but everything adds up.
Immediate Impact of taking $15,000 from a $38,000 balance:
If you have left your company or if you are over age 59 ½, you most likely can take a withdrawal from your 401(k). Here are the consequences of a 401(k) withdrawal:
Taxes: Any pre-tax money and earnings in your 401(k) are taxed as ordinary income when you take a withdrawal.
Opportunity cost: I have already mentioned that any money that you withdraw from your 401(k) robs you of having that money invested for the future.
Mandatory tax withholding: The plan is required by the IRS to withhold 20% of any distribution for Federal taxes. You can avoid this mandatory withholding by rolling your money into an IRA first. If your money is in an IRA, there is no mandatory tax withholding.
Early withdrawal penalty: As mentioned above, if you are under 59 ½, you are subject to a 10% penalty for early withdrawal.
Exceptions to the early withdrawal penalty:
Personal education expenses
Birth or adoption of a child (Up to $5,000)
First time home purchase (Up to $10,000)
Payments to your estate upon death
Military reserve being called up to active duty
Victim of a disaster where the IRS has granted relief
Long-term Impact of taking $15,000 from a $38,000 balance:
CARES Act Provisions
Since we are currently in extraordinary circumstances the Government has passed legislation that provides temporary changes to the normal rules:
Workers who are eligible can take a distribution from their 401(k) (or IRA) in 2020 without penalty or a mandatory tax withholding.
Taxes still apply; however, they can be spread out over the next 3 years.
Distributions can be paid back into the plan over the next 3 years in addition to regular contribution limits. This means that if the money is paid back it will avoid taxation.
In order to be eligible, the worker or immediate family member would need to be diagnosed with Covid-19, or the worker would have to experience adverse financial consequences due to being laid off, quarantined, reduced hours, or otherwise been unable to work due to the virus.
The CARES Act also makes modifications to all 401(k) loans. Employees are eligible to take up to $100,000 or their full vested balance, whichever is lesser. There is also a one-year extension to loan deadlines if a current loan is due in 2020.
While these terms are helpful if you are experiencing financial difficulty because of the pandemic, the same cautions still apply. Any money you take from your retirement account will cost you in lost compound earnings. Your 401(k) should be your last resort to help with current expenses.
If you have time to plan:
If you are in need of money right away and your 401(k) is the only way to get it, then you can make an educated decision to access your funds. It is important to know that sometimes life forces us to change plans and adapt. It is OK. Financial planning is a constant process. If you have time to plan ahead, I recommend setting yourself up so that you don’t have to access your 401(k) unless it is an extreme circumstance. Here are a few recommendations:
Save for the short term as well as the long term: Often we build up our retirement savings because it is convenient and comes right out of a paycheck. Too often, I see young professionals that are maxing out retirement savings but have not put away money for the short term. It is important to build up a liquid cash cushion to fall back on.
Save money while paying off debt: Don’t wait to pay off your debt before getting money into savings. If life happens while you are paying off debt and you don’t have any cash, you will be left with the choice of going into more debt or robbing your future self.
Keep a line of credit open: But don’t use it. Debt can actually be a powerful financial tool if used with discipline. If you have self-control, you may want to consider keeping a credit card with a low interest rate or a home equity line of credit open while you build up your cash cushion. This will provide safety in an emergency situation without you having to alter your retirement plan.
Accessing your 401(k) comes down to a personal choice. It is important to rely on trusted advisors to guide you in the process. Make sure you ask questions so that you feel educated and empowered before you act. If you do need to use the money now, make sure you have a plan to get back on track so that you don’t leave the problem up to the future you.
Assumptions for withdrawal scenario: In this hypothetical withdrawal scenario, a total of $23,810 is taken from the account so that 37% ($8,810) of the withdrawal is set aside for taxes and penalties and the remaining amount ($15,000) is received, leaving $14,190 in remaining balance at age 45. In this hypothetical loan scenario, the loan period is 5 years, starting at age 45, and the loan interest rate is 6.5%. The hypothetical 22-year time frame between ages 45 and 67, assumes an annual income of $75,000 with a 1.5% increase yearly, a personal rate of return of 4.5%, an employee contribution amount of 5%, and an employer contribution amount of 5%. Both scenarios assume there are no additional loans or withdrawals during the hypothetical 22-year time frame. Your own account may earn more or less than this example, and taxes are due upon withdrawal. Loans are repaid into the retirement account using after-tax money, and that money will be taxed a second time when it's withdrawn again.