Raised 401(k) Distribution and Loan Limits Amid Coronavirus

Many people may have money they’re typically not allowed to touch until retirement. This could include money in a 401(k), IRA or similar retirement plan. 

To be clear:

People are almost always advised not to take a 401(k) loan or early distribution. 

These events commonly have a severe negative impact on your retirement plans. You may have to pay a penalty and taxes on early withdrawals.

If the only options are tapping your 401(k) or not putting food on the table for your family, you have to do what keeps your family going.

To make accessing your retirement funds less painful in these crazy times, Congress acted. 

In the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), certain provisions can change how loans and early distributions related to COVID-19 may work to help those in need. 

Here’s what you need to know to see if these options could help your family. 

Keep in mind, this information is still relatively new.

The exact guidance on how these programs work may not be finalized with the appropriate departments despite being in the CARES Act. 

Requirements to Access New Loan and Withdrawal Options

Congress has allowed certain new withdrawal and loan options to help those in financial turmoil due to COVID-19.

Only certain people can access them, though.

In order to qualify for the programs described below, you must meet one (1) of the following circumstances:

• You must have been diagnosed with COVID-19 by a test approved by the CDC
• Your spouse or dependent was diagnosed with COVID-19 by a test approved by the CDC
• You experience adverse financial consequences due to:
  • Quarantine
  • Being furloughed
  • Being laid off
  • Having hours reduced
  • Being unable to work due to lack of child care due to the disease
  • Closing or reducing hours of a business owned or operated by the individual due to the disease 
  • Other factors as determined by the Secretary of the Treasury

The plan you withdraw money from or take a loan from must also be an eligible retirement plan.

While your retirement plan provider doesn’t have to require proof that you meet one of these conditions, you shouldn’t lie to get access to these programs. 

Changes to Loan Limits and Repayments

In order for these loan options to work for you, your employer’s plan must allow them. 

Technically, workplace retirement plans have to amend their plan documents to change how events like early distributions and loans work. 

The law allows plans to provide these options now, but they will have to amend their plan to allow for them within a certain time frame. The amendment will be retroactive, which is what allows these programs to work. 

However, plans don’t have to amend themselves to allow for these options.

If your plan decides not to offer these options, you won’t have access to them.

Increased Loan Limits

Until September 23, 2020, eligible plan participants can now take out loans up to the lesser of $100,000 or 100% of the participant’s vested account balance. 

In the past, these limits were up to the lesser of $50,000 or 50% of your vested account balance.

You have to repay these loans according to the rules of your plan over a limited time frame. 

If you’re uncertain about your ability to repay the loan, the amount you end up not repaying will be considered a distribution subject to taxes and penalties. 

If you end up losing your job for any reason, you have to repay the loan immediately in full. 

Loans taken out prior to coronavirus

If you’ve already taken out a loan in the past and are worried about the ability to repay it, Congress addressed this issue. 

If your repayment was due from March 27, 2020 to December 31, 2020, you can delay your repayments for one year.

Change to Distributions to Remove 10% Early Withdrawal Penalty

If you fall into one of the categories of people mentioned above that can take advantage of an early withdrawal, here’s how it works.

Normally, withdrawals from a traditional retirement account prior to age 59.5 require you to pay both taxes and a 10% early withdrawal penalty.

The CARES Act removes the 10% early withdrawal penalty for COVID-19 related withdrawals on up to $100,000 per participant across all accounts.

Do note:

You still have to pay income taxes on the amount withdrawn.

That said, you may repay the amount withdrawn to avoid paying taxes.

Here’s how the taxes work in general.

Tax impact spread out over three years

The law allows you to spread out the income taxes you’ll owe on your withdrawal over a three year period. 

The law doesn’t specify exactly how this works, so future guidance will be necessary to see how this will be implemented in practice.

Spreading out the tax impact could help significantly depending on the final guidance.

Withdrawing a large amount of money in one year could force you into a higher marginal income tax bracket on part of your withdrawal. This could increase the amount of taxes you pay on it.

By spreading the withdrawal out over a three year period, it may not result in as much income falling into the higher marginal income tax brackets if your income is consistent.

Of course, final guidance has to be issued to share whether this strategy may work.

Repay amount distributed within three years to avoid taxes

The law allows you to recontribute the money you withdraw within three (3) years of withdrawing it.

This isn’t considered part of your annual contribution limits.

Instead, it is treated as a rollover contribution.

When you repay the money, you won’t have to pay taxes on the amount you repaid. There isn’t guidance on how this will work in practice. 

You will need to wait to hear how exactly this will work out. This could get complex. 

Between spreading the tax impact out over three years and repaying over three years, you’ll need to keep meticulous records and watch out for future guidance.

To complicate matters further:

Your tax bracket may be different in each of the three years.

This could impact the amounts of tax paid or not paid due to repayments.

Set money aside for taxes owed

When taking money out, you’ll still owe taxes on it until it is repaid. 

With the option to spread out the taxes owed over three years, it could be tempting to say you’ll worry about it later.

Don’t do this.

When you withdraw the money, figure out the maximum possible amount you would owe in taxes on that money.

Set that money aside immediately and do not touch it.

Wait until you’re done filing your tax returns for the applicable years or have completely repaid the amount you withdrew before touching the money. 

This way:

You won’t go into tax debt, which is one of the worst types of debt to owe.

Should I Consider Tapping My 401(k) or Other Retirement Account?

Tapping your 401(k) or another retirement account should be a last resort. 

Using these options could help put food on the table in a worst-case scenario.

Even so, the implications of borrowing from your future self should not be taken lightly.

If you have options to reduce expenses or find other ways to get access to funds, those may be better options.

Experts consistently warn against borrowing or taking early distributions from retirement accounts for good reasons.

While you may have the best intentions of repaying a loan or distribution according to the rules in the CARES Act, those intentions don’t always end up happening. 

If the money never makes it back to your retirement account, you may have extended the time until you can retire. Alternatively, you may have permanently reduced the money you’ll have available when you can no longer work.

Even with all of that said, these loans and distributions are an option. 

If you can’t feed your family or find another way to keep a roof over your head, this may be your only option.

Which Option Should I Use?

Only you can decide which option, a loan or a distribution, is best for you. There are risks and benefits no matter which option you choose.

Before you take out a loan or a distribution, fully educate yourself about the impact each could have on your finances. 

Consider how it would work out if things don’t go as planned. Have back up strategies for how you’d deal with these alternative outcomes.

Once you’ve looked through all of the options and potential outcomes, choose the option that is best for you. 

In some cases, that means not taking out a loan or distribution and instead using a credit card to cover your costs for now. 

In other cases, a loan or distribution from your retirement plan may be the best option.