April 7, 2020

Edited 05/11/20

Should I Withdraw from My 401(k) Early?

Need to do an early withdrawal from your 401(k) before you reach the age of 59 ½? We compare a 401(k) withdraw to traditional loans.

Due to the impact of COVID-19 on businesses and workers, many Americans are looking for ways to cover their monthly expenses. One source for these funds can be your retirement accounts. Although one should avoid accessing their funds early as a general rule, there are exceptions if there are no other resources available. These funds can be a lifeline for many impacted by COVID-19. With the recently passed CARES Act, there are now additional ways you can access your retirement accounts early, penalty-free.

Early Withdrawals from Your 401(k) or Workplace Plan

When you withdraw from your retirement plans, you have to meet the magical age of 59 ½ before you can access your accounts without paying a penalty. Typically, employees are able to save for their retirement through numerous workplace plans like a 401(k).

If you are in need of cash, the CARES Act has made it possible to withdraw up to $100,000 from your retirement account. While hardship withdrawals are typically allowed for workplace plans, before the CARES Act, they were limited to the greater of 50% of your account value or $50,000. The CARES Act raised that limit to 100% of your account value up to $100,000 as long as you meet these conditions:

  • You or your spouse is diagnosed with the disease OR
  • You have experienced financial hardship as the result of unemployment, furlough, reduced work hours, or unable to work due to unavailable child care resources.

The other good news is that those under 59 ½, are not subject to the usual 10% early withdrawal penalty. Even though the penalty has been waived, you are subject to the ordinary income tax on the amount withdrawn.

Although the CARES Act waives this penalty, withdrawals are still subject to income tax. To lessen the hardship, the tax due on the withdrawal is allowed to be spread over three years beginning in 2020. You can also avoid the income tax altogether by paying back any amount withdrawn within the three-year time period. By paying back the amount withdrawn, not only would you be able to restore your balance, but you can also avoid paying income tax on the withdrawal.

Loans from Your 401(k) or Workplace Plan

There is another option to consider as an alternative to your 401(k) or other workplace plans. The CARES Act relaxes borrowing restrictions, making short-term borrowing accessible if you need cash fast.

First, you will need to check with your human resources department or plan administrator on your particular workplace plan’s borrowing provisions. While it has become easier for employers to add this provision to their plan, you may find that your plan does not have a loan provision.

If your plan does have a loan provision, the CARES Act allows you to borrow up to 100% of your current balance with a limit of $100,000. Typically loans made from your workplace plan must be paid back within five years from your loan date. However, the CARES Act extended that time to six years, allowing an additional year.

While the proceeds from the loan are tax-free, the loan must be repaid with after-tax dollars, which is similar to other loans that you might receive from a bank or other lender. It cannot be repaid through contributions to your account that are typically before-tax. Often times, your employer has the ability for you to repay the loan via payroll deduction. 

These loans are not based on your creditworthiness. There is no credit check or approval process for the loan. However, there are consequences if the loan is not repaid within the stated time period. If you fail to repay the amount you borrowed, the IRS will classify the remaining balance as a withdrawal and that amount will become taxable.

Like a withdrawal, the amount of your loan is removed from your investments. As you make loan payments, your payment amount is used to purchase new shares in your account. These loans are not interest-free. A small portion of your monthly payment is allocated as an interest payment. The good news is that interest payments are also allocated to your account as opposed to being paid to a bank or lender. 

Comparing a 401(k) or Workplace Plan Loan to Other Lending Options

For responsible borrowers, a loan from your 401(k) or other workplace plans can be a good alternative to other lending options. Rates are typically lower than personal loans from banks and other lenders. In addition, rates are lower than utilizing a HELOC or other forms of home equity borrowing.  Credit cards are also an option for covering short-term needs but are often at higher rates and can have a negative impact on your credit score. If you have the cash flow to make monthly payments, a 401(k) or workplace loan can be the most economically sustainable way to borrow.

Unlike other lending options, borrowing from your 401(k) or workplace loan is easier to get and has no impact on your credit score. This is a large advantage compared to the other lenders like a bank or other financial institution. However, you should remember that any funds you withdraw from your retirement accounts are not continuing to grow and will not be there to support your retirement unless you repay them.

Which Option Should I Choose?

The decision you should make is really based on your financial situation. If you can comfortably make monthly loan payments over a five-year period, then borrowing from your 401(k) or workplace plan might be the right option for you. It guarantees that the money you receive will find its way back to your account over time. This will reduce or eliminate the negative effects on your retirement savings. 

If you feel you may have difficulty repaying the loan, but still need money, a withdrawal may be the better choice. However, a withdrawal that is not repaid will have an adverse effect on your retirement account and should be avoided, if possible. If your need is short-term and you can replenish the account in three years or less, then a withdrawal could be best for you.

While tapping into your retirement savings is not ideal, there are ways to do it responsibly. Although, most Americans are underfunded for retirement and should continue to save. However, in the event short-term liquidity is needed, there are ways to access your funds in a responsible way. Whether you withdraw or borrow from your retirement accounts, having a plan to return the money to the accounts overtime should be part of your strategy.