O.K., we get it. A lot of people are strapped for cash right now and really need relief. Many of those people may be tempted to take money from their 401k, and for some, that might truly be the best option.
401k advisors are no doubt experiencing a surge in plan participants exploring their options for using their retirement funds to help them deal with sudden financial difficulties brought on by the coronavirus-fueled economic crisis.
But just because it has been made easier and less expensive for plan participants to access 401k funds doesn’t mean it’s the right solution for everyone.
Yes, the CARES Act changed laws to allow hardship distributions from qualified retirement accounts like 401ks for coronavirus-related purposes of up to $100,000 for those under 59½, without incurring the standard 10% early withdrawal penalty. The limit on 401k loans for “qualified individuals” increased from 50% of a participant’s vested account balance up to $50,000 to now 100% of the participant’s vested account balance up to $100,000. And many recordkeepers have waived fees on hardship withdrawals and loans from their 401ks.
Moves like this are intended to help those in dire need access their funds in the most inexpensive way possible, but aren’t meant to open the floodgates for any participant to raid their 401ks whether they really need to or not.
Advisors are in a unique position to counsel 401k plan participants considering raiding their 401ks to help them through the current situation, and there are a lot of points to bring up to help them think it through.
“Unless you’re in a dire circumstance, taking a withdrawal of any significant amount after the market has dropped 30% is not a good option, and should be avoided,” Sri Reddy of Principal Financial Group recently told 401k Specialist. “Instead, think of this moment as the right time to look at your other daily expenditures to right-size expense levels and stay invested.”
Those facing difficulty covering the mortgage, student loans or car payments should exhaust other possibilities before taking a 401k distribution. Home refinancing is booming with historically low-interest rates, and many lenders have responded to the crisis by allowing borrowers to delay payments for a few months.
Trying to ‘time the market’
The allure of trying to “time the market” might tempt some who really aren’t facing a “hardship” to take money from their 401k now just because they can, thinking they’ll reinvest when the market bottoms out. It’s a risky move that’s unlikely to pay off for the average investor.
During the 2008 market crash, a 2011 Aon Hewitt and Financial Engines Inc. study of 425,000 workers’ 401ks reported by Forbes found about 5% of those 55 or older dumped all the stock in their 401ks and then missed the 2009 rebound.
By going to “cash in a crash” and taking a distribution now, a participant is essentially locking in what is now simply a paper loss. And that distribution might even bump them into a higher tax bracket.
While participants can avoid taxes on a hardship withdrawal if the money is put back in the account within three years, history tells us many people won’t pay it back (with after-tax dollars, no less). If it isn’t returned, taxes will need to be paid over a three-year span (instead of in one year, per the CARES Act).
Loans taken from 401ks need to be paid back within six years (previously five before CARES Act).
Using a distribution to pay for discretionary items
Suppose a participant has long wanted to renovate the kitchen or finish their basement. Now that it’s easier and less expensive to take a loan from a 401k, they might see this as a perfect opportunity to finally get it done—and might try to justify it by reasoning they are now spending so much more time at home.
Not so fast. Financial experts caution against taking out retirement money for non-essential expenses, particularly in times of financial uncertainty.
A generational crisis like this might also lead some people to rethink their priorities, and move bucket-list items like finally taking that dream vacation or buying a boat from the back burner.
Yes, you only live once, but if you live a long life, those later years will be much more comfortable with a healthy retirement account. Taking money from a 401k now will have a bigger impact down the road.
Don’t stop contributing to your 401k
Not only should taking a distribution be a last resort; it should also be a last resort to stop contributing to your 401k, even if the employer has eliminated its 401k match due to the crisis.
Dana Anspach, founder of financial planning firm Sensible Money and author of the book, Control Your Retirement Destiny, recently told GoBanking Rates that one of the worst things retirement savers did during the 2008 financial crisis was they stopped contributing to their 401ks or other retirement accounts.
Not only should you continue to contribute to your retirement account, but also you should consider increasing your contribution. If you invest more while the market is down, you’ll get more bang for your buck, Anspach said. “This is a buying opportunity of a lifetime.”
When it comes to retirement accounts, she said to remember that you’re saving for the long term, so stay the course rather than make a drastic move during this time of stress.
“You have to look at the potential outcomes over five years, not over a few weeks or months,” Anspach told GoBankingRates, adding that there’s a quote she saw that sums up what retirement savers should do now: “I’ve learned it’s best not to get off the roller coaster in the middle of the ride. Let it come to a stop.”
CARES Act irony
It is somewhat ironic that the CARES Act makes it easier for people to take money from their 401k, but also encourages people NOT to take money out of their retirement plans when they would normally be required to.
The Cares Act provision that waives required minimum distributions (RMDs) for calendar year 2020 provides relief to individuals who would otherwise be required to withdraw funds from retirement accounts during the economic slowdown due to COVID-19.
Because RMDs are calculated based off account balances as of the end of the prior year, the ability to defer them could help millions of retirees from having to take them at a time when their portfolios are down substantially from near-record highs of Dec. 31, 2019. The provision also helps individuals avoid additional taxable income for the year 2020.
“Allowing retirees to defer RMDs is a good provision for a couple of reasons,” Principal’s Reddy concluded. “First, RMD calculations could be based off much higher account values from year-end, which don’t reflect today’s reality. Secondly, taking withdrawals now will lock in paper losses on the amount withdrawn and not allow retirees to participate in market gains.”
Pretty strong arguments for not taking money out of your retirement plan unless it is absolutely necessary.
Veteran financial services industry journalist Brian Anderson joined 401(k) Specialist as Managing Editor in January 2019. He has led editorial content for a variety of well-known properties including Insurance Forums, Life Insurance Selling, National Underwriter Life & Health, and Senior Market Advisor. He has always maintained a focus on providing readers with timely, useful information intended to help them build their business.
