underscored 401k piggy bank
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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't have 20% of your 401(k) distribution withheld for taxes, you still owe them.

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.

The best news is that if you get back on your feet and can afford to pay the money back, you can actually return the withdrawal to your 401(k) any time over the next three years, and those deposits won’t be subject to the usual annual contribution limits. Plus, if you return the money, you’ll be able to get a refund of the taxes you paid.

Finally, with the stock market back closer to its highs than its lows, if you do decide to sell some retirement holdings to take a withdrawal, you won’t be selling at the bottom, so selling is a much better situation than it was just a few months ago.

But a 401(k) withdrawal has its downsides

While this is clearly an advantageous time to make a 401(k) withdrawal if you really need to, it’s still only advisable as a last resort. There are several reasons, starting with the most obvious: If you use your retirement money now, you won’t have it when you need it for retirement.

But it’s more than just the money you’re withdrawing. You’re not only draining your retirement account of principal, you’re also losing the additional interest and dividends that money would earn if you left it in place. Because retirement funds are typically invested over decades and not just for the short-term, that can add up to a lot of compounded interest and dividends that would go by the wayside.

Also, even with the relaxed tax rules, you may still be in a higher tax bracket now than you will be when you retire, especially if you’re part of a married couple where one-half is still working at the moment. You’re giving up one of the advantages of a 401(k), which is to delay the taxes on your saved money until retirement, when the bill is likely to be smaller because your income is lower.

And if your employer plan decided not to make the coronavirus-related changes from the CARES Act — or only made some of them — you may not have the option to make withdrawals under the relaxed rules. You might still be able to apply for a “hardship withdrawal,” but you could then be subject to the standard 10% penalty, depending on how you use the money, and you don’t have the option to pay it back.

A 401(k) loan avoids taxes entirely as long as you pay it back

If you or your plan aren’t eligible for the relaxed 401(k) withdrawal rules, or you don’t like the idea of permanently taking money out of your retirement account, you can instead consider a 401(k) loan. This is just like any other loan, except instead of borrowing money from a bank or a friend, you’re borrowing your own retirement money with the promise to pay it back.

There are several advantages to utilizing a 401(k) loan instead of a withdrawal. First, unlike a withdrawal, you don’t owe any taxes on a loan, so long as you pay the money back in the allotted time, which is usually five years but can vary depending on your employer’s plan. There’s also no penalty associated with a 401(k) loan, regardless of your coronavirus status.

“If you are borrowing an amount that you can safely repay within a relatively short period of time, 1 to 2 years, the cost could be minimal or possibly nothing at all,” said Browning.

And the most attractive feature of a 401(k) loan is that the interest you pay on the loan goes back into your 401(k) account. That’s right — you’re literally paying interest to yourself, with the payments taken out of your regular paycheck. That’s a lot more enticing than paying interest to a bank, which could make a 401(k) loan a good alternative to slowly paying down debt with just a minimum credit card payment each month.

Interest on your 401(k) loan gets paid back into your own 401(k) account.

The CARES Act also made a few temporary changes to 401(k) loans, though none as drastic as the changes made to 401(k) withdrawals. But if you utilize a 401(k) loan, any payments due between March 27 and December 31, 2020, can be postponed. This is true even if you took out the loan before the coronavirus crisis hit, though again, your employer plan must adopt these specific provisions of the CARES Act.

Also, for people affected by the coronavirus pandemic, the CARES Act increased the maximum amount of a 401(k) loan to $100,000 or 100% of your vested balance, whichever is lower. This is double the normal amount of $50,000 or 50% of your vested balance, and again, is subject to the specific rules adopted by your plan.

But you’ll be in worse shape if you can’t repay your 401(k) loan

The major downside with a 401(k) loan happens if you end up not being able to repay it within the established time frame. If that occurs, you’ll not only be taxed on the money as if it were a withdrawal, you’ll also have to pay the 10% withdrawal penalty, leaving you worse off than if you had just taken a penalty-free coronavirus-related distribution.

Also, if you leave your job for any reason — including getting laid off — you’ll suddenly be under the gun to pay off your loan much faster. According to IRS rules, once you’re no longer working for your current employer, you need to have any outstanding balance from a 401(k) loan back in an eligible retirement plan by the due date (including extensions) for filing your federal income tax return, meaning mid-October of the following year at the very latest.

So if you’re deeply concerned about your job, a 401(k) loan can come with some risk. You’re also only able to take out a 401(k) loan from your current company — you can’t do it with a 401(k) from a previous employer or if you’re currently unemployed. And not all employer plans offer a loan option, so you’ll need to check the specific rules for your 401(k) account.

Consider all your options before taking either a 401(k) withdrawal or loan

The recent coronavirus-related changes to the 401(k) rules do make an early withdrawal or loan more attractive than usual. But make no mistake about it: There’s still a long-term cost. So before you do it, first look at all the other possibilities for acquiring cash or cutting your expenses.

“Alternatives for cash would be any emergency fund that you have or other accessible savings such as non-retirement accounts earmarked for other goals,” suggested D’Agostini. “You could also tap home equity, and open up a line of credit. This makes sense as long as it is a short-term solution.”

While a 401(k) withdrawal or loan may make sense right now, look at all your other options first.

But if you’re considering relying on credit cards to make it through the crisis, make sure you’re paying as little interest as possible. Either look for a credit card that charges 0% interest on purchases for the first 12 to 21 months you have the card, or consolidate your existing debt onto a credit card with a low-interest balance transfer offer.

Related: If you need to go into debt, keep these three rules in mind

Also, if you have a Roth IRA, you may want to use it to make a withdrawal instead of a 401(k), as you won’t have to pay either taxes or penalties on any early withdrawals of contributions from a Roth IRA (though withdrawing earnings is usually subject to taxes and penalties).

And if you haven’t already done so, create a spending plan before you take money from anywhere, so you can see exactly where your cash is going each month. A household spending plan is easier to create than a full-fledged budget, and makes it easier to stash away some savings for the future by “paying yourself first” as you get back on your feet.

Having money issues due to the coronavirus pandemic? Read CNN Underscored’s previous stories in this series: