PHOTO: iStock

It’s normally a bad idea to dip into your retirement savings early. Not only are you shrinking the pot of money you’ll need when you’re ready to actually retire, but taking cash out of a 401(k) usually means additional taxes and penalties if you haven’t yet turned 59½ years old.

However, recent changes in the law have made it less onerous to get access to your retirement account early if you’ve been hit financially by the coronavirus pandemic and resulting economic downturn, which means it might be worth at least considering whether it’s time to use that money.

You should first examine all the other possibilities before breaking open your retirement piggy bank. But as we’ve said before in our series on handling money issues during the coronavirus pandemic, an unprecedented crisis sometimes requires unprecedented solutions.

“I am usually very hesitant to tell anyone to withdraw money from their 401(k) plan,” said Chris Browning, the founder and host of Popcorn Finance, a personal finance podcast. “However, we are dealing with an economic situation that is unique in so many ways. If you have lost income and you do not have a significant emergency fund or access to a home equity line of credit at a low interest rate, using money from your 401(k) plan could be a significantly cheaper method of borrowing cash than a credit card or personal loan.”

So if you’re down to the last straws and need the money from your 401(k) now, you’ll want to consider the pros and cons of your two options: making an early withdrawal from your 401(k), or taking out a loan against it.

401(k) withdrawals: No penalties and no mandatory tax withholding

Thanks to the CARES Act passed by Congress in March, there are several temporary changes to the rules for 401(k) accounts that can mean a withdrawal makes more sense than usual. But in order to qualify under these new rules, you’ll need to certify that you’ve been financially affected by the coronavirus pandemic.

“You must have been diagnosed with coronavirus, had a spouse or dependent diagnosed with it, been laid off, furloughed, quarantined, or your hours have been reduced, and as a result have suffered adverse financial consequences,” explained Jody D’Agostini, a certified financial planner and advisor with Equitable Advisors. “Others that qualify are those who have had to stay at home to take care of children because you have not had access to daycare, and business owners that were shut down due to the pandemic.”

Also, your 401(k)’s plan sponsor — meaning your employer, or former employer if it’s an old account — needs to adopt the new CARES Act rules, and they’re not required to do so. Check with your HR department or the firm that administers your plan to find out if it’s eligible for a coronavirus-related distribution.

But if both you and your plan are eligible, the normal 10% penalty for making a 401(k) withdrawal before you turn 59½ years old is currently waived on distributions of up to $100,000. That’s a major roadblock that normally dissuades people from using their retirement savings early, and it’s been eliminated for the rest of 2020.

The mandatory 20% federal tax withholding on any early withdrawals you make from a 401(k) account has also been waived for the rest of the calendar year. But be careful on this one. Even though your plan won’t take taxes out of your distribution, you still owe taxes on the money.

Even though you won
Even though you won't have 20% of your 401(k) distribution withheld for taxes, you still owe them. PHOTO: iStock

The difference is that, instead of having to pay all the taxes up front, you currently have the option to spread the payments out over the next three years. “For example, if you were to withdraw $15,000 before the end of 2020, you could report $5,000 in income on your federal returns for 2020, 2021, and 2022,” explained Browning.

That could be extremely helpful if you currently need as much cash as possible. On the other hand, if you can afford to pay the taxes now and you’re in a lower tax bracket than usual because of reduced hours or a layoff, you might be better off paying them all this year. Either way, “be sure that you put away some cash to pay the income tax,” advised D’Agostini.