As part of the CARES Act, Congress expanded distribution rules and added favorable tax treatment for 401k’s and IRAs. In order to qualify under the CARES Act provision, you, your spouse, or a dependent must have received a positive COVID diagnosis or you have suffered a financial blow from the quarantine. This means you have been furloughed, laid off, had a pay cut, or can’t work due to lost childcare.
For 401k plans that already include a loan provision, the amount available has expanded to the new limit of 100% of your vested balance up to $100,000. The total of loans and distributions from all accounts is $100,000 per individual.
What Should we Know About the Loan Repayment Schedule?
The loan repayment schedule has been extended one year. Under the regular rules when you take a loan from a 401k you must immediately start repaying the loan through payroll deduction and pay it all back within 5 years. When you qualify under the CARES Act provision, you have one year before repayments start and then the five-year clock starts. So, you basically have six years from the date you take the loan to fully repay it. Interest does accrue during the first year.
The fees and interest for a 401k loan may be less than for a personal loan and you pay the interest to yourself. However, the loan repayments are made with after-tax dollars and when you withdraw those dollars later in retirement you will pay tax on it again.
A risk of taking a loan is that if you were to lose your job with a loan outstanding on your 401k, it comes due immediately, and if you cannot pay it all back in full, it is treated as a withdrawal and taxes will be due. To qualify for the CARES Act 401k loan provisions, you must apply for the loan before September 23, 2020.
For 401k and IRA distributions under the CARES Act that are not loans, the 10% penalty for those under 59 ½ is waived and the taxes due can be paid over three years, 2020, 2021 and 2022. You add 1/3 of the distribution to your taxable income each year.
A new feature is that you may repay coronavirus-related distributions from a retirement account. If you complete the repayment within three years from the date of distribution, the repayment will be treated as a direct trustee to trustee transfer and you will not owe taxes. You could amend prior tax returns to recover the taxes you paid. Coronavirus related distributions must be made by December 30, 2020.
While these enhanced provisions may sound attractive, when you take the money out of your 401k it is no longer invested. That will seriously reduce what you have available later for retirement. It will be very hard to catch up. My recommendation is to use everything else available to you before taking a loan or distribution from your retirement account. Use the expanded unemployment benefits and the recovery check in the CARES Act. Use your own emergency funds and then of course, tighten your budget as much as possible. Don’t view your 401k as a short-term emergency fund. It takes a lifetime of work and regular contributions to build a 401k large enough to replace your income in retirement. A cracked nest egg reminds me of Humpty Dumpty. It can’t be put back together again. Distributions and loans from your retirement accounts should be a last resort.
Do you have questions about your 401k? We are here to help. Please feel free to reach out!