On March 25, 2020, the Senate unanimously passed a $2 trillion stimulus package called the CARES Act – the Coronavirus Aid, Relief, and Economic Security Act. The primary purpose of the Act is that it boosts unemployment insurance payouts and aims to send relief checks to many Americans. In addition, it also looks to aid small businesses and some large corporations negatively impacted by the Covid-19 virus. Included in the bill are several measures that impact retirement savers. Among them, are beneficial changes to both plan withdrawals and 401(k) loans. In the following, we’ll discuss whether a retirement plan withdrawal is better than a loan from your 401(k).
Here are the three provisions that focus on every American retirement saver:
Penalty-Free IRA & 401(k) Plan Distributions
You are allowed to take a penalty-free IRA and/or 401(k) plan distribution of up to $100,000. This includes all types of plans, including the popular Self-Directed IRA and 401(k) plans. Further, it eliminates that mandatory withholding tax for 401(k) withdrawals. Normally, about 20% of a 401(k) withdrawal is withheld for tax purposes. Of course, all traditional withdrawals will be taxed. However, you now have three years to pay the taxes on your distributions. An eligible distribution is one made to someone:
- who is diagnosed with SRS-COV-2 or COVID-19 by a test approved by the CDC,
- whose spouse or dependent is diagnosed with one of the two diseases, or
- who experiences adverse financial consequences as a result of being quarantined, furloughed
Normally, when one takes a distributions from the account prior to age 59 1/2, taxes would be due and a penalty would apply. This 10% early withdrawal penalty has been waived for qualified distributions due to the coronavirus. As we stated earlier, taxes will be due, however you can spread them out over three years.
401(k) Plan Loan Changes
The Act increased the 401(k) plan maximum loan amount from $50,000 to $100,000. Again, this applies to all 401(k) plans, including Solo 401(k) plans. In order to take advantage of the loan, you must, of course, have a 401(k) and the plan must allow for loans. A 401(k) loan must be paid back in full within five years. Payments must be made at least quarterly at an interest rate of at least Prime. Currently, the Prime Rate stands at 3.25%.
The CARES Act also has a provision for those who currently have an outstanding 401(k) loan balance. All payments due through the end of the year can be delayed for one year. For example, if you have a payment due on April 1, 2020, you do not have to make your payment until April 2021. This goes for all payments due by December 31, 2020.
Required Minimum Distributions (RMD) are due once you reach a certain age. Prior to the SECURE Act, that age was 70 1/2. However, that age was pushed back to 72. If you had already begun the RMD regime, you are not required to take a distribution for 2020. If you turned age 70 1/2 in 2019 and have not taken your RMD for that year, you must still do so. It is unclear if the April 1 deadline is still set. We’ll update with any new info as soon as we have it! To be clear – all 2020 RMD payments are canceled for this year. Required distributions are expected to resume in 2021.
Retirement Plan Withdrawal vs. a Loan
There are a few things to consider about these new laws. Deciding between a retirement plan withdrawal and a 401(k) loan is an important decision. Let’s go over the pros and cons of each option.
If you only have an IRA, your only option is a distribution from your IRA. All distributions from a traditional plan (IRA or 401(k)) will be taxed. However, instead of getting hit with a large tax bill next year, you can pay it out over the next three. For example, if you withdraw $30,000, you can pay taxes on $10,000 at a time. It’s a decent option, especially if you are under 59 1/2. Not having to pay the 10% early withdrawal tax is a huge deal. Therefore, you would get the full $30,000 and not $27,000 ($3,000 penalty).
A plan withdrawal should be a last ditch option, especially for IRA-only savers. Even though taxes are being spread out, you do still have to pay them. Further, anything taken from the plan will no longer be working for you. Lastly, studies have shown that distributions taken from a retirement account are rarely made back. It’s also never a great idea to withdraw while the markets are down.
One last provision of the CARES Act is the ability to re-contribute the distribution. You have three years to pay back the amount you withdrawn. Any amount that is paid back will not be taxed. Therefore if you withdraw $10,000 and contribute it all back to any retirement plan, no taxes will be due!
On the other hand, if you have a 401(k) plan and your plan has a loan option, it’s generally a better idea to borrow retirement funds than to withdraw them. A loan gives you tax- and penalty-free use of your funds. So long as you pay back the loan in a timely matter, you won’t face adverse tax consequences. If you need $10,000 to get through these tough times, you can take a loan for that amount.
Another advantage of the loan is that you paying back into your 401(k) plan. This includes any interest that is due for the borrowed amount. Plus, you make continue to fund your 401(k) at your leisure. Keep in my mind, that if you default on the loan, it will then be treated as a taxable distribution. Of course, if you do not repay, it’s like you have taken a taxable distribution anyway.
60 Day Rollover
One last option you may consider is the 60-day rollover. With this, you have free reign of your retirement funds to with as you wish for 60 days. You can then roll over your retirement funds into a different account and face no adverse tax consequences. You must transfer the entire amount taken, or else face taxes on the amount not rolled over.
This is a great option for IRA-only holders and 401(k) users who do not have access to a loan. If you need short-term use of some retirement funds, you can use the money and then re-contribute to your retirement plan. This also gives you incentive to return money to your retirement plan. The tax advantages of IRA and 401(k) plans make it so it’s best to keep them funded at all times.
Overall, the CARES Act offers many important benefits to American individuals, businesses, and retirement account holders. If considering taking advantage of a penalty-free IRA distribution or 401(k) plan loan, it is important to consider the items mentioned above. Obviously, dipping into your retirement funds should be a last resort. At the very least, the government has made it easier to tap those funds without adverse penalties.