There are pros and cons of withdrawing from your 401k or IRA early, even with the COVID-19 hardship distribution rules. It may be tempting, but it’s essential to realize the implications.
Many of our employer-partners have asked how we can help their employees experiencing financial difficulty during the current pandemic crisis. At Kalsee, we have several options, including low-cost loans and financial counseling.
We’re also finding that with the temporary Coronavirus-related relief options, many individuals are taking 401k or IRA withdrawals or loans from their 401k instead of other forms of borrowing. Sometimes this is to your advantage. However, the key to making the right decision is understanding the ramifications, your present tax situation, and what happens if you leave your employer with an outstanding 401k loan.
Understanding your options
During the COVID crisis, distributions from 401k plans and IRAs may be accepted in certain circumstances. But not everyone qualifies. Much depends on your situation and if you have been ill with COVID-19.
Saundra Ivy, Kalsee Retirement and Investment Services Advisor located at Kalsee Credit Union, believes it’s critical to understand the laws relating to Coronavirus-Related Distributions (CRDs), and while it can be a viable option for some, it may not always be the right move. “First, it pays to understand exactly what a CRD is and how it can impact your finances,” adds Ivy. “There are also specific instances where you may or may not qualify for an approved distribution.”
To explain, a CRD is a distribution sponsors/employers could add to their retirement plans as a result of the CARES (Coronavirus Aid, Relief, and Economic Security) Act. Here, a withdrawal is made from an eligible plan to a qualified individual, with the qualifying dates of January 1, 2020, to December 31, 2020. The aggregate withdrawal limit is up to $100,000 from all plans and IRAs; however, the plan sponsor may add the CRD option but limit the available amount to a dollar amount less than the $100,000.
There are several ways to qualify for a CRD Distribution:
- You are diagnosed with the virus SARS-CoV-2 or coronavirus disease 2019 (COVID-19) by a test approved by the Centers for Disease Control and Prevention (CDC).
- Your spouse or dependent is diagnosed with SARS-CoV-2 or COVID-19 by a test approved by the CDC.
- Additionally, you experience adverse financial consequences because of being a) quarantined, being furloughed or laid off, or having work hours reduced due to SARS-CoV-2 or COVID-19; b) unable to work due to lack of childcare due to SARS-CoV-2 or COVID-19; or, c) because of closing or reducing hours of a business that you own or operate due to SARS-CoV-2 or COVID-19.
- These adverse financial consequences were expanded to include: a) Having pay or self-employment income reduced due to COVID-19; b) a job offer rescinded or start date for a job delayed due to COVID-19; or, c) the closing or reduction of hours of a business owned or operated by an individual’s spouse or member of the individual’s household due to COVID-19.
Tax Implications May Apply
Ivy stresses the importance of understanding the tax implications fully and to always discuss a possible withdrawal with your tax adviser first. “This ensures you won’t have any unhappy consequences come tax time, especially if you’re struggling.”
While the 10% early withdrawal penalty does not apply to coronavirus-related distributions, the distribution is still subject to federal and state income taxes. However, the participant can pay the tax liability over three years (2020, 2021, and 2022). Additionally, the participant may repay the withdrawal to their retirement account to avoid the tax liability on the amount repaid.
Hardship Distribution Rules
Some retirement plans offer Hardship Distribution exceptions. And while not required, these may allow participants to receive hardship distributions from a participant’s elective deferral account, made only if the distribution meets these two requirements:
- Due to an immediate and heavy financial need. Here, the employer determines if a participant has an ‘immediate and heavy’ financial need based on the plan terms and relevant facts and circumstances. It entails that:
- The distribution isn't greater than the amount of the immediate and heavy financial need, including the amounts necessary to pay any taxes resulting from the distribution.
- The employee has obtained all other currently available distributions (including distribution of ESOP dividends under section 404(k), but not hardship distributions) and nontaxable (at the time of the loan) plan loans, including all other plans maintained by the employer.
- The employee doesn’t make elective deferrals to the plan for at least six months after the hardship distribution.
- Limited to the amount necessary to satisfy that financial need. The amount of a hardship distribution must be limited to the amount necessary to satisfy the need. And unless the employer has knowledge to the contrary, the employer may rely on the employee’s written statement that their need can’t be relieved from other available resources, including:
- Insurance or other reimbursements, liquidation of the employee’s assets, the employee’s pay, discontinuing elective deferrals and after-tax employee contributions, plan loans, or reasonable commercial loans.
An employee doesn’t have to use alternative resources if doing so would increase the amount of the need. For example, an employee requesting a hardship to purchase a principal residence doesn’t have to obtain a plan loan if the loan would disqualify the employee from obtaining other financing.
Safe Harbor Rules
Under the “Safe Harbor” rule in IRS regulations, an employee is automatically considered to have an immediate and heavy financial need if the distribution is for:
- Medical care expenses for the employee, the employee’s spouse, dependents, or beneficiary.
- Costs related to the purchase of an employee’s principal residence (excluding mortgage payments).
- Tuition-related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents, or beneficiary.
- Payments are necessary to prevent the employee’s eviction from the employee’s principal residence or foreclosure on the mortgage on that residence.
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
- Certain expenses to repair damage to the employee’s principal residence.
Tax and Penalty Implications
At tax time, you’re responsible for applicable taxes based on your current tax situation, and it’s wise to consider this as money you’ll owe. “Always consult your tax adviser or request more information to see how it will play out with individual situation,” stresses Ivy.
In addition to federal and state income taxes, a hardship withdrawal is subject to an early 10% withdrawal penalty. This penalty is deducted directly from your distribution.
Borrowing from your 401k is another option that can give you access to cash. But be cautious; most plans require immediate repayment if you leave. This is another implication often overlooked by an individual when considering their access to funds.
According to the 401k Help Center, “If you quit working or change employers, the loan must be paid back. If you can't repay the loan, it is considered defaulted, and you will be taxed on the outstanding balance, including an early withdrawal penalty if you are not at least age 59 ½. ... You have no flexibility in changing the payment terms of your loan.”
Count on Kalsee
We encourage you to contact us if you have questions before you make a withdrawal. We can help recommend your best course of action. Additionally, if you need immediate access to cash, we offer other affordable financial options — rather than withdrawing or borrowing from your 401k plan or IRA.
- Consider other options to obtain cash. We offer #LifeHappens loans and our convenient Skip-a-pay options (available in December or January) for extra funds.
- Ask Saundra for help. She’s ready to provide sound investment guidance and sensible options when it comes to funding. Contact Saundra Ivy at (269) 382-7898.
- Work with our free financial counselors. Click here to schedule a time convenient for you. Aspire Financial Counseling is available for those who need more in-depth help.
More To Explore
1 KALSEE Retirement and Investment Services Financial Professionals are registered representatives of CUNA Brokerage Services, Inc. Representatives are registered, securities sold, advisory services offered through CUNA Brokerage Services, Inc. (CBSI), member FINRA(Opens in a new Window)/SIPC(Opens in a new Window), a registered broker/dealer and investment advisor, which is not an affiliate of the credit union. CBSI is under contract with the financial institution to make securities available to members. Not NCUA/NCUSIF/FDIC insured, May Lose Value, No Financial Institution Guarantee. Not a deposit of any financial institution. CUNA Brokerage Services, Inc. is a registered broker/dealer in all fifty States of the United States of America.
This information is not intended as tax or legal advice. Please consult your tax advisor regarding your particular situation prior to making a 401k withdrawal or loan.
Additional source for this post: Rose Street Financial, Kalamazoo, Mich.
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