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Americans will soon be able to take penalty-free withdrawals from their 401(k)s, but experts say think twice about using retirement savings

Sally Anscombe

Cash-strapped Americans struggling with the fallout of coronavirus may soon be able to tap into their retirement savings to cover bills, loan payments and everyday expenses. But experts say that while it's tempting to cash in, Americans should exhaust every other option first. 

Late Wednesday, the Senate unanimously passed a $2 trillion stimulus package called the CARES Act — the Coronavirus Aid, Relief, and Economic Security Act — that boosts unemployment insurance payouts and aims to send relief checks to many Americans. To provide additional ways for Americans to access cash, the bill also allows people to take a withdrawal of up to $100,000 from their retirement savings, including 401(k)s or individual retirement accounts, without the typical penalty

In the past, if you need to access those funds before age 59½, you generally have to pay a 10% penalty on any amount you take. The general exceptions to that rule include education expenses, buying your first home, covering massive medical debts or being ordered by a court to provide alimony or child support. If you're over age 55 and you've lost your job, whether you were laid off, fired, or quit, you can also pull money out of your 401(k) or 403(b) plan from your current employer without penalty.

While the new withdrawal exemption may help cover the short-term expenses associated with coronavirus, experts say Americans should think twice before tapping into their retirement funds.

"It sends a signal to people that this is a normal thing to do — and up to $100,000 — that's crazy," Monique Morrissey, an economist focused on retirement security at progressive think tank Economic Policy Institute, tells CNBC Make It.

For many, this relief simply isn't an option

Only about half the workforce has a retirement account, says Olivia S. Mitchell, professor of insurance/risk management and business economics and public policy, and executive director of Wharton's Pension Research Council at the University of Pennsylvania.

And many have far less than $100,000 saved. A recent report found pre-retirees, Americans 56 to 61, had a median balance of $21,000 in their 401(k) accounts in 2016, which is the most up-to-date data on file. That total reflects almost 30 years of savings. Younger generations do not fare much better. Older millennials (32 to 37) have about $1,000 saved in their 401(k)s.

Not only that, but employees with retirement accounts tend to be the higher paid, better educated and longer-term workers. "Therefore allowing people to tap into their retirement accounts won't help the millions who have no accounts," Mitchell says. "Those with no accounts are also likely to be the people that will be needing the most help."

Additionally, Mitchell predicts that the U.S. will see an increase in applications for early Social Security benefits, particularly if the recession is long and hard. "People taking early benefits will end up with a lifetime of lower payouts, and if they already ate into their 401(k)s, they'll be more likely to face shortfalls in their later years," she says. 

Consider the costs of taking retirement money

Giving Americans the ability to take $100,000 in penalty-free withdrawals is probably rooted in the right place, says Timothy Ellis Jr., a certified financial planner with Memphis-based Waddell & Associates.

But those withdrawals could have a long-term negative impact on retirement plans and needs moving forward, Ellis says.

Especially because the worst time to withdraw investment assets is in the middle of a dramatic market downturn. Because the investments are worth less, consumers may have to withdraw a larger percentage of the account, Ellis says. 

Then there's the opportunity cost to raiding your retirement savings early. "Accessing retirement plan accounts, especially for younger workers, can put a permanent dent in plan balances," Ellis says. In fact, for an investor who makes steady retirement contributions over their career, the amounts saved during the first 10 years may end up accounting for half of their retirement account balance at age 65.

That's because compounding is one of the most powerful tools to boost retirement savings, and making a withdrawal, especially during the early stages of investing, reduces that ability, Ellis adds. Even a smaller withdrawal adds up in the long run. A $5,000 balance today could be worth $57,900 in 35 years, assuming a 7% annual rate of return.

You also can't forget about taxes: While the new rule allows for penalty-free withdrawals, the money isn't totally free. "There will still be ordinary income taxes owed on withdrawals from traditional 401(k) deferral, employer matching and profit sharing balances," Ellis says. 

Under the new stimulus package, however, consumers would be allowed to spread out the income taxes over a three-year period, so consumers wouldn't take such a massive hit on next year's taxes. 

The Senate's CARES Act is expected to pass the House of Representatives on Friday, but there are still steps retirement plan providers will need to take to make this new benefit available to consumers. It's also worth noting that under the recently passed SECURE Act, new parents are able to take $5,000 penalty-free from retirement accounts once regulators and employers provide guidance. But many 401(k) plan providers have delayed access to the new benefit, saying they need additional guidance from regulators and employers. 

So while Wednesday's bill aims to expand the ability to take penalty-free withdrawals, there's no guarantee that Americans will be able to immediately take advantage of the benefit immediately during the coronavirus outbreak.

Other options if you need cash

If you are experiencing financial hurdles because of the recent coronavirus outbreak, Ellis recommends exhausting other resources before tapping into your retirement plan balance. 

First, consider using any emergency savings you may have. "We recommend our clients keep three to six months' worth of living expenses in cash for emergencies, which this would definitely fall under," Ellis says. 

If you own a home, you could look into getting a home equity line of credit since housing values have been on the rise and interest rates are low. "You may have the ability to utilize the equity in your home at a low carrying cost," Ellis says. 

If you need cash and don't have any emergency savings or home equity on hand, consider applying for a personal loan from your bank, which is generally used to consolidate debt or make a big purchase. The average interest rate for a two-year personal loan was about 10.2% in November 2019, according to the latest data from the Federal Reserve.

Keep in mind that the rate depends on both your credit and on the length of the loan, as shorter loans tend to have lower APRs. If you have bad credit, you may be facing an interest rate of up to 36%.

If you do need to dip into retirement savings, you may be better off taking a 401(k) loan. These loans are not taxed, but you can only take up to half of your vested account balance — and not more than $50,000, no matter how high your balance. 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 typically also still need to be working at the company to take a loan, most 401(k) plans do not offer former employees loans.

If those options don't work, you could also tap into a Roth IRA if you have one. With these accounts, you can withdraw any money you've invested at any time, without taxes or penalties. But again, remember there's an opportunity cost to using that money.

Even if you do need to take a withdrawal to cover your expenses, make a plan for next time. Even $5 or $10 a week can add up over time when you're trying to build an emergency savings fund.

"Some people may actually benefit from this in a modest way," Morrissey says. "But many people will also make bad decisions prompted by this [penalty-free withdrawal] — it will give people ideas they might not otherwise have acted on."

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