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New parents shouldn't count on penalty-free 401(k) withdrawals just yet

Byba Sepit | Getty

In an effort to help new parents successfully navigate the increasing costs of raising a family, last month lawmakers signed off on new rules that will allow eligible Americans to tap into their retirement savings. But it may be months before 401(k) plan sponsors are able to offer these benefits — and for some families that may be too late.

The rule, part of the comprehensive retirement legislation known as the SECURE Act, gives Americans who've had a baby or adopted a child within the past year the option to take a withdrawal of up to $5,000 from their retirement savings, including 401(k)s or individual retirement accounts, without the typical 10% penalty.

The changes sparked James Bednar's interest: He has a baby and feels the financial squeeze of trying to manage the cost of having kids. "I don't know that I necessarily need the money, but my son is 5 months old, and it's expensive to have kids these days, especially up here in the Northeast," Bednar, who lives in New Jersey, tells CNBC Make It.

The 43-year-old father of two called up his 401(k) provider, Principal, to get more information and ask about the steps required to start a withdrawal.

That's when he learned that while the law had gone into effect, he wasn't going to be able to take advantage of this benefit for a while, if ever.

Principal says the company needs more guidance from regulators before making this 401(k) benefit available to the public. "Principal is thrilled about the passing of the SECURE Act and what it means for financial security for Americans," the company said in a statement, adding that "there are many details to work through with such sweeping legislation, and this particular provision has many questions that will have to be answered by regulators."

And Principal is far from the only company struggling to accommodate these new rules. CNBC Make It spoke with nearly half a dozen major plan providers, including Charles Schwab, Fidelity and Vanguard, and they all confirmed they were not yet able to offer these so-called "baby withdrawals" to eligible 401(k) investors.

"I was taken aback a bit," Bednar says. "I read the law, and it seemed very clear cut and straightforward to me."

But it turns out, it's not that simple.

New rules of the road to retirement

Late in December, President Trump signed a $1.4 trillion spending deal that, among other provisions, contained the SECURE Act. The legislation introduced a number of overhauls to retirement accounts, including raising the age when people need to take minimum withdrawals as well as giving small businesses the ability to join together to participate in multi-employer 401(k) plans.

It also gives new parents one year to take advantage of penalty-free baby withdrawals — up to $10,000 for couples with separate retirement accounts. While you can opt to repay the withdrawal amount, this is not a loan and you're not required to adhere to a strict repayment process.

I don't know that I necessarily need the money, but my son is 5 months old, and it's expensive to have kids these days, especially up here in the Northeast.
James Bednar

Until now, you could only take penalty-free withdrawals from your 401(k) before 59½ if you had education expenses, bought a home for the first time, incurred massive medical debts or were ordered by a court to provide alimony or child support. For other circumstances, you had to pay a 10% early withdrawal penalty, plus taxes on the funds you withdrew.

According to the new law, these changes affect any withdrawals (also known as distributions) made after December 31, 2019, according to the National Association of Plan Advisors.

Change takes time

If you have an IRA, it may be easier to take these baby withdrawals right away. Currently, Charles Schwab and Vanguard both tell CNBC Make It that they are already able to accommodate requests for IRA distributions.

"Looking at the birth and adoption provision specifically, we made this withdrawal available to IRA account owners, obviously assuming they meet the requirements," says Shannon Nutter, head of participant strategy and development for Vanguard's institutional business.

But if you're interested in taking money from your 401(k), it will likely be months, potentially up to a year, before you're able to take advantage of the new benefit. And some people will never get to use the benefit.

Retirement plan providers read the new law's withdrawal exemption as an optional plan feature, which means that the decision whether to include this benefit rests with the employer.

It's similar to existing rules allowing you to take a loan from your 401(k) or a financial hardship withdrawal. Roughly 15% of 401(k) plans don't allow account holders to take distributions when they are experiencing a financial hardship.

In some cases, the employer will need to amend their 401(k) plan, a process and time frame that will vary by company. "Many employers only meet quarterly, semi-annually or annually to make design changes to their retirement plan. In addition, we expect employers will want to educate themselves on the pros and cons of offering this new distribution type, which may delay their employees' ability to receive a qualified birth/adoption distribution," Schwab spokesman Mike Peterson tells CNBC Make It.

Beyond getting employer buy-in, plan providers will also need to set up back-end systems to track which plans are allowing these types of withdrawals, figure out the best ways to collect documentation such as birth certificates or adoption paperwork from consumers and educate their customer reps on how to answer questions.

"All of that takes time," says Michael Hadley, a lawyer with the D.C.-based law firm Davis & Harman. "If you want to take a distribution from your plan, the plan, and its service provider, can't just say 'OK, you can have it.' It's gotta be documented."

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Individual companies, as well as trade groups such as Society of Professional Administrators and Recordkeepers (SPARK) have sent letters to U.S. Department of the Treasury and the IRS asking them to weigh in on what information exactly companies need to be collecting from consumers and what tax laws apply.

As it stands, normally the IRS requires plan providers withhold 20% of any withdrawal for taxes, since the money you contribute to a 401(k) is taken out of your paycheck before taxes are applied. So if you take out $1,000, you'll only get about $800 right away, and that's assuming you don't have to pay the 10% early withdrawal penalty.

But there's no mention in the new law whether this 20% withholding rule applies to baby withdrawals. If it does, parents will really only receive up to $4,000 and plan providers will need to withhold the rest for taxes.

This just one example of the many questions plan providers are putting to regulators. In fact, Hadley who works with SPARK on legislative and regulatory changes, says that of all the provisions in the SECURE Act, the baby withdrawal change is the one that has the biggest unanswered questions.

Plan providers are "in unprecedented waters," Hadley says, adding that typically there's a long window, at least six months, between when a law is passed and when it goes into effect, giving companies time to get the details sorted out. This time, that implementation period was just five business days during a holiday week.

Typically a major change to create a new plan feature "will take six months to a year, and often that clock starts once we have the answers to all the questions we really need, " Hadley says.

Other options if you need some cash

If you are a new parent who is experiencing some financial hurdles, check with your provider to see if you can take a baby withdrawal from an IRA now, if you already set up and deposited funds into this type of account.

With a Roth IRA, you may not even need to claim a baby withdrawal to take out money. Within these accounts, you can withdraw any money you've invested at any time, without taxes or penalties. And after your account has been open at least five years (and you've reached the age 59½), you can withdraw any investment earnings without incurring the typical 10% penalty.

If you only have a 401(k) and are facing major debts, you can check to see if your plan allows hardship withdrawals. Keep in mind that these are classified as emergency situations that pose "an immediate and heavy financial need of the employee." You will have to pay taxes on this money, taxed as ordinary income, and you may also have to pay the 10% penalty.

There's also the option to take a 401(k) loan. These loans are not taxed, but you can only take up to half of your vested account balance — but not more than $50,000, no matter how high your balance. And all loans need to be repaid within five years with interest (this is set by your plan, based on the prime rate, which is currently about 4.75%), or you'll be hit with taxes.

You could also apply for a personal loan from your bank, which is generally used to consolidate debt or make a big purchase. On average, those with credit scores below 680 will be paying higher interest rates for a personal loan than the average credit card APR of 16.97%, according to an analysis by loan marketplace Credible.

For personal loans, the rate not only depends on your credit, but also on the length of the loan, as shorter loans tend to have lower APRs. If you feel that paying off your debt will take longer than three years, you may be subject to a higher rate, Credible finds.

Think twice before using retirement money

Using retirement savings should be a last resort, financial planners say. Unless you're dipping into a Roth IRA, the money will still be taxed at the person's ordinary income rate, says John Petrides, a wealth management expert with Tocqueville Asset Management.

A married couple with a household income of $100,000 and one child would typically owe $6,684 in federal taxes using the standard deduction, according to Credit Karma's Income Tax Calculator for 2019. But let's say the couple took a combined $10,000 penalty-free withdrawal from their retirement accounts. That bumps their household income up to $110,000 for that year and they now may owe roughly $8,500 in taxes.

There is also an opportunity cost to raiding your retirement savings early. A $5,000 balance today could be worth $57,900 in 35 years, assuming a 7% annual rate of return. Every dollar counts when attempting to save for retirement.

But at the end of the day, parents will do anything for their kids and taking a hit on retirement savings may be a better option than going into debt.

Overall, the SECURE Act will lead to "several beneficial shifts" in retirement savings and planning, says Charlie Nelson, CEO of retirement and employee benefits for Voya. And that includes allowing new parents to access 401(k) funds if needed.

"We see this [withdrawal exemption] change as a promising opportunity for young families and first-time parents who might be strapped with an unanticipated medical bill due to the rise in healthcare costs today," Nelson says.

But while plan providers like Voya are in favor of changes, until regulators, employers and financial companies can get on the same page, new parents like Bednar are stuck in limbo.

"There seems to be a lot of people who will miss out on this opportunity because they will have passed the window," Bednar says. "For some folks, this could be a game-changer. It's not a tremendous amount of money, but it helps."

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