Here's What You Need to Know Before You Tap Into Your 401(k)

The pandemic affected more than physical health in 2020. Business closures, job loss, and limited financial relief meant many Americans' savings accounts took a serious hit.

In 2020, The CARES Act made it easier to take a withdrawal from a 401(k) or other qualifying retirement account by waiving the usual penalty. More than 2 million Americans took advantage of this benefit last year. We’re in a fresh new year, but the coronavirus pandemic is still going to have economic and health impact in 2021. If you’re wondering how to make ends meet, there are several things you should know about short- and long-term impact of borrowing from your retirement funds, and what alternatives to consider.

How 401(k) Withdrawals Work

Normally, your contributions to a 401(k) retirement plan come out of pre-tax income. They then grow tax-free, and you pay taxes when you withdraw the money in retirement (when, presumably, you’re in a lower tax bracket than in your working years).

If you take a withdrawal before age 59 ½, it’s considered an early distribution of your retirement fund, and it’s subject to penalties. Typically, this means you'll have to pay income tax and a 10% penalty on the withdrawal amount. There are some limited options for a “hardship withdrawal” or "hardship distributions" that waive the penalty. From January 1-December 30, 2020, the CARES Act waived the 401(k) early withdrawal penalty. However the government did not extend this provision of the CARES Act for 2021.

The new legislation that does impact 2021 is called the Consolidated Appropriations Act, signed into law on December 27, 2020. Although it does not extend the time to take a coronavirus-related distribution from your 401(k), it does allow people to take distributions if they are affected by qualified disasters other than the pandemic. Qualified disasters include events that are declared disasters by the President between January 1, 2020 and 60 days after the enactment of The Act. You have 180 days from the enactment of The Act to take a qualified disaster distribution.

Pros and Cons of Cashing Out 401(k) Vs. a 401(k) Loan

An important question to ask yourself is whether you intend to pay the money back into your retirement plan.  The pros and cons of borrowing from 401(k) or other qualifying accounts are a little different from the pros and cons of withdrawing from a 401(k).

What is an early withdrawal from 401(k)?

A 401(k) is a retirement savings plan, so dipping into that money early comes with a 401(k) withdrawal penalty. COVID response in 2020 included a temporary lift on penalties on qualifying distributions, but this is no longer in effect for 2021.

The pro side is that the money is yours, minus whatever penalties and taxes you have to pay. You don’t need to figure out a repayment plan (or reinvestment, since you’re paying into your own account). The con side is that this option cuts retirement funds you’d planned to live on later, and you lose more up front to penalties, taxes, and fees.

What is a 401(k) loan?

Not all 401(k) plans allow a loan option, but many do. You can borrow from a 401(k) without penalty, as long as you can meet the amortized repayment schedule.

Funds you receive through a 401(k) loan aren’t subject to penalties or taxes if you repay on time, so you keep more of your money. The “interest” is also really a payment to yourself, since it goes back into your 401(k) plan. The interest can help recover some of the gains you might have earned from investment performance, so depending on how the market is doing, you may not see a loss from having money out of the market.

 If you don’t stick to the repayment schedule, however, you will face penalties and taxes on the portion that’s outstanding. The IRS will treat the amount you haven’t repaid on time as an early distribution, not a loan. Funds you pay back into your 401(k) also come from your after-tax dollars in your paycheck, not before-tax earnings.

Comparing interest rates on a 401(k) loan, interest rates on a bank loan, and expected returns from the market can help you determine whether a 401(k) loan is your most cost-effective option.

Alternatives to 401(k) Loan or Early Withdrawal

Just because you can tap into your 401(k) doesn’t mean it’s the best decision for your financial situation. Consider the full range of options before dipping into your 401(k) plan:

• Roth IRA: Unlike a 401(k) or a Traditional IRA, you can cash out your Roth IRA contributions at any time.  Before withdrawing any earnings, consult a financial advisor to ensure you meet the conditions for a tax-free and penalty-free withdrawal.
• Stock investments outside of your retirement portfolio: If your brokerage account balance is at a high, it may be reason to consider selling some of your shares to get some cash. Talk with a financial advisor about your portfolio’s performance and how to adjust your investment plan.
• Home Value Investment: Tapping into your home equity can be a viable alternative to using retirement savings or other investments. You won’t be adding to your debt load, and you won’t lose out on possible long-term, compound earnings the way you might be withdrawing investments too early.
• Home equity loan: Unlike a Home Value Investment, a home equity loan operates like a traditional loan by charging interest and implementing a monthly payment plan. However these often require exceptional credit to qualify and the ability to take on more monthly payments.
• Personal loan from a bank or other financial institution.  Personal loans often come with hefty interest rates and shorter durations than other types of financing.
• Mortgage forbearance: This isn’t a source of funding, but it might be a way to ease some financial strain. Some lenders may accept initial requests for CARES Act mortgage forbearance until February 28, 2021. You’ll still have to pay the full balance of your mortgage eventually, but pausing your payments for a few months could help you get back on your feet.

Protect Your Finances Now and in the Future

If you’re wrestling between, “I need my 401(k) money now” and, “I’m worried how early distributions affect my retirement,” you’re not the only one struggling to reconcile present and future needs.

If it’s possible, try to hold off from taking early distributions. The 401(k) withdrawal rules after 59 ½ years of age change to eliminate the dreaded 10% penalty. Choosing an alternate financing strategy like accessing your home equity instead of retirement funds might give a financial advantage to some families.

It’s also important to consider the impact of portfolio losses and earlier distributions than you’d planned on your overall retirement strategy. Even if you’re 60, if you didn’t plan to touch retirement money until age 65 or 68, taking funds now may not give you a lot of time to rebuild the balance and account for lost opportunities for growth.

Build Back Your 401(k) Savings

For some families, the question of whether to tap into 401(k) funds is water under the bridge. You needed money urgently, your retirement funding was available, and you took it. So, what now? Talk to a financial advisor and consider these strategies if you need to catch up to meet your retirement funding target:

• Review your 401(k) allocations: Typically, advisors recommend investing more conservatively as you near retirement to minimize losses if the market slumps. But you want to leave yourself enough opportunities to take advantage of compounding returns, too. A professional advisor can help you determine the right balance of risk for your portfolio.
• Max your contributions: People over 50 can add a $6,500 catchup contribution to the maximum 401(k) contributions allowed.
• Access alternate sources of funding: If your regular savings are low and you’re behind on retirement savings, a resource like home equity can shore up other financial weak points. If you’ve got substantial equity and you’re in a rapidly appreciating home market, a Home Value Investment may help provide funding for short-term cash flow and pad retirement funds.
• Consider your retirement timeline: The difference between retiring at age 62 or age 65 can be significant in terms of the benefits you can collect and the savings you can contribute toward your long-term plans. The financial toll of 2020 may force some people to rethink their retirement date.

In many cases, taking from your 401(k) should be a final resort. You may have other options available to provide you with short-term cash you need, without compromising your long-term retirement plans. But even if you already tapped into your retirement savings, you may be able to use a combination of savvy budgeting and alternate financing strategies to rebuild savings for the future and take care of your family’s needs now.