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The coronavirus pandemic has upended the personal finances of millions of workers and their loved ones. And one recent trend is of particular concern.
Many workers who have been furloughed or laid off are now strapped for cash. And they’re considering borrowing money from their 401(k) instead of using other sources of funds.
Advisers recommend tapping all other sources of money before borrowing from your 401(k).
“Please stay away from retirement accounts,” says Chris Chen, a certified financial planner with Insight Financial Strategists. “The long-term damage is absolutely horrible.”
The economic crisis caused by the coronavirus pandemic, which is closing businesses and forcing millions out of work, makes it even less appealing.
“We like to use 401(k) loans as a last resort, especially in a challenging financial environment,” says Dan Galli, a certified financial planner with Daniel J. Galli & Associates.
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Reason to avoid 401(k) loans
Galli also advises against 401(k) loans for this reason:
Plan sponsors, according to the IRS, may require an employee to repay the full outstanding balance of a loan if he or she terminates employment or if the plan is terminated. And that could put even more financial stress on your finances if you’re already desperate for living expenses.
Even worse: If you, the employee, are unable to repay the loan, then your employer will treat it as a distribution and report it to the IRS.
“The country is littered with stories about folks that took 401(k) withdrawals with every attempt to pay the money back, but never got around to it,” says Charles Sachs, a certified financial planner with Kaufman Rossin Wealth. “Imagine the lost growth over a 20-, 30- or 40-year period. If people think they have it tough now, they should imagine when they are in their 80s without the benefit of a nice sized 401(k).”
One bit of good news: You, the employee, can avoid the immediate income tax consequences by rolling over all or part of the loan’s outstanding balance to an IRA or eligible retirement plan by the due date for filing the Federal income tax return for the year in which the loan is treated as a distribution.
What to tap instead
So, where might you find money for living expenses? Well, for starters consider that each option has its pros and cons.
But in the main, borrowing from family, a home equity line of credit and credit cards should be used before borrowing from a 401(k), says Galli.
Thomas Scanlon, a certified financial planner with Raymond James, also recommends tapping your Roth IRA. “Your contributions to the Roth IRA can be withdrawn any time, income tax and penalty free,” he says. “This is because the contributions go in after tax.”
If you’re owed a refund, file your 2019 tax return right away. That’s another source of cash, says Rita Cheng, a certified financial planner Blue Ocean Global Wealth. Likewise, follow up on your stimulus check if you haven’t received that yet.
And, for some, accessing the cash value in your life insurance is another source of funds, says Cheng.
You might be able to take a hardship distribution from your 401(k) plan. Typically, it’s allowed for an immediate and heavy financial need, and limited to the amount necessary to satisfy that financial need. But experts generally advise against this tactic. That’s because because you will have to pay taxes on the distribution, and you can’t pay the distribution back into your 401(k).
Bottom line: List all your available options and create a plan that will best position you to weather a difficult storm, says David Mullins, a certified financial planner with David Mullins Wealth Management Group.
When a 401(k) loan is the best option
To be fair, a 401(k) loan may be the best option, depending on the expected need and the length of time, and what other options are available. But remember “you are pulling from funds in a down market and missing out on a potential recovery,” says David Shotwell, a certified financial planner Shotwell Rutter Baer. “It may be less interest cost, but the long-term cost can be much greater.”
The right way and the wrong way: If you borrow money from your 401(k) plan, there are best practices to follow. When you take a loan, you are selling securities, says Leon LaBrecque, a certified financial planner with Sequoia Financial Advisors. And given that, Robert Braglia, a certified financial planner with American Financial & Tax Strategies, advises against taking the money on a pro-rata basis across all investment options but rather specify which ones, probably cash or bonds, will be sold.
The Cares Act: According to Ed Slott, a CPA with Ed Slott and Company, the CARES Act increases the maximum loan amount for qualified individuals to the lesser of $100,000 (reduced by other outstanding loans) or 100% of the account balance, and, two, allows qualified individuals to take up to $100,000 of penalty-free coronavirus-related IRA and company plan distributions during 2020. If you’re a qualified individual, either the loan or distribution could be a source of funds for living expenses.
Robert Powell is the editor of TheStreet’s Retirement Daily (www.thestreet.com/retirement-daily) and contributes regularly to USA TODAY. Got questions about money? Email Bob at [email protected]
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