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Dipping into 401(k) Retirement Savings: Red Flags Abound

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In order to combat the coronavirus pandemic, the U.S. government is allowing retirement savers to temporarily dip into their 401(k) and 403(b) plans. But should they?

Congress has passed the CARES Act ("Coronavirus Aid, Relief and Economic Security Act.") Part of its expansive $2 trillion-plus mandate comes with financial relief to help offset job losses and cutbacks in hours worked. 

If you've got a family member whose employment status has been adversely disrupted by the pandemic, such legislation provides a few new ways to tap into your workplace retirement savings account like those found in 401(k) and 403(b) plans. These include two key provisions:

1.) Penalty-Free Withdrawals

In pre-coronavirus times, taxpayers ages 59 1/2 and younger were typically forced to pay a 10% excise tax when money is taken out of a qualified retirement plan account. The exceptions to such a penalty include those with a permanent disability, an IRS levy or medical debt above 10% of their income.

Also, taxpayers have been allowed to make so-called Substantially Equal Periodic Payments, or SEPPs. This is where someone can take a penalty-free withdrawal with specified annual distributions for a period of five years -- or, until the account-holder turns 59 1/2, whichever comes later. Income tax must still be paid on the withdrawals.

In 2020, the CARES Act lets those who normally are encouraged to keep building their retirement savings – i.e., those aged 59 1/2 or younger -- to take out as much as $100,000 without being penalized. 

Keep in mind an important caveat. If you withdraw funds this year because of coronavirus-related circumstances, these distributions will be counted as income. Taxes assessed on those distributions by the IRS, however, can be spread over 2021 and 2022. 

2.) Taking a 401(k) Loan 

In many 401(k) and 403(b) plans, participants can borrow against their account savings. In those plans, however, how much you can take and how quickly you must repay such a loan can vary greatly.

A rule-of-thumb used broadly to illustrate how such borrowing practices work by many planning experts is that you might be able to take a loan for as much as 50% of your 401(k) account's total, up to a maximum of $50,000 in a 12-month period. In a typical plan, you are required to pay that loan back, including interest, within a certain number of years. 

The CARES Act has expanded these usual limits for plans that allow loans. This year, in such plans you can take a loan up to $100,000 or 100% of your vested account balance, whichever is less. Again, you're going to be paying yourself back that borrowed amount with interest. 

So, what's the downside to greater flexibility to take advantage of retirement savings in these times when short-term finances might be thrown into flux?

A basic concern that IFA's wealth advisors and tax planning professionals might raise with clients is whether any coronavirus-related money issues have created dire enough individual financial circumstances to risk drawing down on their hard-earned retirement savings. 

Likewise, borrowing from a 401(k) or related workplace retirement plan -- even for a relatively short timeframe -- figures to reduce the amount available to grow over time. That means you're likely to have less to tap into during your retirement years. 

The finer points of the act's increased flexibility around retirement plan borrowing also raise some other red flags worth reviewing about borrowing from a 401(k) or 403(b) plan under any circumstances.     

At the time you take a 401(k) loan, you don't pay taxes on the amount received. Still, failure to repay such a loan on time will likely result in taxes and penalties coming into play.

For example, if you leave employment while you have an outstanding 401(k) loan, your remaining loan balance is considered a distribution, unless you repay it. Along these lines, the 2017 Tax Credit and Jobs Act (TCJA), has extended repayment deadlines from two months to the filing deadline day of your federal tax returns. 

By taking a distribution on any unpaid balance on a 401(k) or 403(b) plan loan, however, you're basically putting yourself in a position with the IRS of increasing your taxable income. Also, if you're age 59 1/2 or younger, you'll be subject to a 10% early withdrawal penalty. 

As with a withdrawal, borrowing from a 401(k) means you won't be investing money you've taken out of your retirement account. In essence, you'll lose out on any growth by your funds above what you might be paying back through installments and interest payments. 

Another point worth noting: By borrowing from a 401(k) or 403(b) account, you're repaying yourself with after-tax money.  

If you're facing a real immediate cash crunch, the CARES Act certainly opens new avenues to explore in terms of protecting your current household cashflow and personal balance sheet. At the same time, this new legislation probably includes enough financial planning and tax nuances to make chatting with an IFA advisor and tax planner worthwhile.

You should feel free to reach out to one of our wealth advisors at: 888-643-3133. John Dahlin, head of IFA Taxes, is also available to handle your tax questions. A certified public accountant (CPA), he can be contacted directly by phone (888-302-0765) or email ([email protected]). 

This is intended to be informational in nature and should not be construed as tax advice. As a division of Index Fund Advisors, Inc., IFA Taxes provides a wide array of tax planning, accounting and tax return preparation services for individuals and businesses across the United States. IFA Taxes does not provide auditing or attestation services and therefore is not a licensed CPA firm. IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. Federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter herein.
Certified Public Accountant (CPA) is a license to provide accounting services to the public awarded by states upon passing their respective course work requirements and the Uniform Certified Public Accounting Examination.