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Is a 401(k) the answer to your financial troubles this year?
You need $5,000 right now. Where do you get it? No, that’s not a hypothetical question, at least not for many Americans who have lost their jobs since the pandemic started. After trimming budgets, draining emergency funds, and borrowing whatever you can, retirement savings often start to look like piggy banks just waiting to be cracked open.
There’s something to be said for that. Your retirement savings is your money after all, so you can use it however you choose. But while the government has changed the rules surrounding 401(k) withdrawals this year, that doesn’t mean you don’t pay a price for taking one. Weigh the following pros and cons of 401(k) withdrawals to decide if it’s the right move for you.
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Three reasons to take a 401(k) withdrawal
Here are a few reasons you may want to consider taking a 401(k) withdrawal if you need some extra cash right now.
1. There’s no early withdrawal penalty
Normally, you pay a 10% early withdrawal penalty if you withdraw funds from your 401(k) before age 59 1/2. But the CARES Act changed the rules for this year to help people out during the pandemic. For 2020 only, you can withdraw funds from your 401(k) at any age and you won’t pay the early withdrawal penalty.
You will still owe taxes on your withdrawals, unless the money comes from a Roth 401(k). However, the rules surrounding taxes on retirement withdrawals are also different this year. More on that below.
2. You can spread your tax liability out over three years
You usually have to pay taxes on 401(k) withdrawals in a single year. You still have the option to do this in 2020, but if doing so would significantly raise your tax bill, you can choose to spread the tax liability over three years instead. So if you withdraw $3,000 this year, you could pay taxes on just $1,000 of your withdrawal in 2020, then another $1,000 in 2021, and the final $1,000 in 2022.
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It’s up to you to decide if this is advantageous. If your income is lower this year than normal, it might make more sense to pay taxes on your full withdrawal this year rather than potentially paying more in a future year when your income is higher and you may be in a higher tax bracket. But the added flexibility available in 2020 is a plus for those who are worried about the potential effect of the withdrawal on their taxes.
3. It’s better than falling behind on your bills
Sometimes, you just don’t have a better option. If a 401(k) withdrawal is the only way that you can pay your bills without taking on costly credit card debt, do it. Leaving your retirement savings alone isn’t worth it if it threatens your current financial security and your ability to save more for retirement in the future.
Only withdraw as much as you need and keep seeking out alternative sources of funding. Look for a new job if you’ve lost yours, start a side hustle, or consider applying for a personal loan with a reasonable interest rate.
Two reasons not to take a 401(k) withdrawal
Here are a couple of reasons you might not want to take a 401(k) withdrawal.
1. You don’t really need the money
The government may have eased the restrictions on 401(k) withdrawals, but you should only take advantage of this if you absolutely need the money. Taking money from your retirement account sets you back. That forces you to save more money per month going forward in order to afford to retire according to your original schedule.
Say you have $25,000 saved for retirement and you’re hoping to get to $1 million. If you’re 35 and hope to retire at 65, you must save about $653 per month, assuming you earn a 7% average annual rate of return. Now let’s say you withdraw $5,000 this year, leaving you with only $20,000 in your retirement savings. If you still want to have $1 million by 65, you must save about $753 per month – $100 more – every year thereafter to have enough. It’s doable, but you can save yourself a lot of hassle by just leaving your retirement savings alone if you don’t actually need the money.
2. You could withdraw money from another source
Obviously, if you have an emergency fund or other personal savings to draw upon, you should use this before tapping your 401(k). You might also prefer to withdraw funds from a different type of retirement account, like a Roth IRA, before your 401(k) if you have one.
Roth retirement accounts are funded with after-tax dollars. That means you pay taxes on your contributions the year you make them, and then you can withdraw your contributions tax-free later. There’s no penalty on contribution withdrawals at any age, but you normally pay taxes and penalties for withdrawing earnings before you’ve had the account for at least five years and before you turn 59 1/2. But the early withdrawal penalty is waived this year, and you can spread your tax liability out over several years, just as you can with a 401(k).
This could be a better choice than your 401(k), especially if you just limit yourself to withdrawing your personal contributions. If you do that, you won’t owe taxes at all.
Taking a 401(k) withdrawal to help you out this year is a personal decision. If you do tap your savings, remember to craft a new retirement plan when you are able to begin saving again so that you can keep yourself on track for a secure future.
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