FA 100

Thinking about tapping your 401(k) due to Covid? Here's what you need to know

Key Points
  • The CARES Act made it much easier for those impacted by the coronavirus pandemic to draw on retirement savings before age 59½.
  • Here's what to consider before taking either a coronavirus-related distribution or a loan from a retirement account.
Jamie Grill | Getty Images

If you've nearly drained your savings due to the coronavirus pandemic but have a retirement account, it's now easier than ever to draw it down.

While taking money out of such an account before retiring is generally something financial advisors say to avoid, it may make sense for those who have been impacted by the crisis, including the millions of Americans who are unemployed, struggling to pay bills and cover basic expenses.

"We typically want to look at retirement accounts as last resorts, but I'm very fond of saying when you can't eat today, you'll worry about tomorrow, tomorrow," CPA and certified financial planner Jeffrey Levine told CNBC's Darla Mercado during the CNBC Financial Advisor Summit. "Some people are unfortunately in that situation where this is it, this is the only asset they have left to tap."  

What changed due to Covid-19

The federal CARES Act, enacted in March, made it much easier for Americans under age 59½ to access the funds stashed in eligible retirement accounts, including employer-sponsored 401(k) plans, 403(b) plans and individual retirement accounts.   

The CARES Act "was really about providing liquidity, and liquidity in a multiple of different ways," Megan Gorman, an attorney and managing partner at Chequers Financial Management in San Francisco, said during Tuesday's FA Summit.

This year, you can take out up to $100,000 from eligible retirement plans without incurring the usual 10% early withdrawal penalty. In addition, people who make such a withdrawal have up to three years to pay the tax liability on the money taken out.

We typically want to look at retirement accounts as last resorts, but I'm very fond of saying when you can't eat today, you'll worry about tomorrow, tomorrow.
Jeffrey Levine
director of advanced planning at Buckingham Strategic Wealth

"This is really powerful, but what's really going to be key here is the definition of a qualified individual," said Gorman. To be able to take a coronavirus-related distribution, you or your family must have been hit physically or financially by the Covid-19 crisis, including having a positive test, losing a job or seeing reduced income due to the pandemic.

The CARES Act also made it easier for folks to take larger loans from retirement plans. It doubled the maximum amount people can take out as a loan to $100,000 and made it so people can take out their entire vested balance — the total amount in the account. It also extended repayment terms, meaning that people can take up to six years to pay the loan back.

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One key difference between taking a coronavirus-related distribution versus a loan is that different plans can decide which loan benefits to take, according to Levine, director of advanced planning at Buckingham Strategic Wealth on New York's Long Island.

"It's really incumbent upon plan participants to reach out to their 401(k) providers and their plans and their companies, and inquire as to what the options are for them specifically," he said.

When to draw down your retirement account

The pandemic has brought many American families an extreme amount of financial stress that might not end anytime soon. People have drawn down their cash reserves, are getting less in unemployment benefits and may be starting to struggle to put food on the table, according to Gorman.

"When you get to that level of desperation, that's sort of when you start to look at the retirement plan," she said, adding that it's best used to pay bills, keep housing and avoid credit card debt with high interest rates.

When working with clients who are facing a crisis, Gorman said it's important to know the rules of options available to help aid decision-making at a time when they may be losing sleep and stretched thin.

401(k) strategies: Megan Gorman and Jeffrey Levine at CNBC FA Summit
401(k) strategies: Megan Gorman and Jeffrey Levine at CNBC FA Summit

"Half of the equation is financial, but the other half is psychological," said Gorman.

It's also important for advisors to help clients see all possibilities, according to Levine. It's the job of the advisor to "look at the client's available resources, to look at what expenses they have including debt options, and see what the best available path is," he said.

Before drawing down a retirement plan, clients may be able to ask for flexibility on certain payments, such as mortgages, credit cards or even private student loans. They may also have access to another retirement account, such as a Roth IRA, that they can withdraw some money from without penalty, said Levine.

Withdraw or loan?

It's important for clients to understand that coronavirus-related distributions and retirement account loans are just some of the tools they have access to in an overall financial toolbox, said Gorman.

Depending on your unique circumstance, it might make sense to take one option over the other to tap into retirement savings. For example, if you're facing lots of financial uncertainty, a distribution that you don't have to pay back may make more sense, said Gorman. And because of the CARES Act, you have up to three years to deal with the related taxes.

Half of the equation is financial, but the other half is psychological.
Megan Gorman
Managing Partner at Chequers Financial Management

On the flip side, a loan may make sense if you think you'll be able to pay it back, especially in the extended time frame.

"At the end of the day, each option represents different benefits and drawbacks," said Levine. "It's just a matter of sitting down with a client and asking what's best for them."

In addition, it's important that financial advisors work with their clients to understand the tax implications of each option and work out what makes more sense over time. If you're an advisor who doesn't do taxes, working with a firm that does tax forecasting can be a big added benefit, said Gorman.

"The game is not won by who has the lowest tax bill in any one year; the game is won by creating the lowest tax bill over the course of an individual's lifetime," said Levine.