The stimulus package allowed workplace retirement plan participants and IRA owners to tap into their retirement accounts and withdraw up to an aggregate $100,000 without penalties for COVID-19 related purposes. Usually, with the exception of certain situations, by tapping into your retirement account prematurely, and that is before age 59.5, you will have to pay a 10% penalty. This penalty was waived.
Deferred Tax Payments
You can also elect to pay the federal tax on the distribution over 3 years or repay the distribution within a 3-year period to the account from which you’ve taken the distribution.
No Required Minimum Distributions
In addition to that, the stimulus bill waived the required minimum distributions (RMDs) through the end of 2020. Now, retirees who turned age 72, don’t have to take mandatory withdrawals from their pre-tax retirement accounts, such a Traditional 401(k), 403(b), Traditional IRAs, a SEP IRA and some other accounts. RMDs are based on the account holder’s age, life expectancy, and account balance. Under normal circumstances you need to calculate your RMD based on the account value on December 31 of the previous year. The 2020 RMD will be based on the December 31, 2019 account balance value – when the market was near a historical high.
If you don’t take the RMD you will face a hefty penalty fee of 50% on the money you were supposed to withdraw.
The reason behind waving RMDs is to not force people to sell in a down market and buy them some time until the market recovers. To those who are already retired or nearing retirement this 30% market drop was a huge hit. Many would even need to stay at work for a few years until the market calms down and rebounds.
Should You Dip Into Your Retirement Accounts?
As you can see, the intentions of both provisions are good – to help people during this tough period by giving them access to so much needed cash. But to me it seems kind of contradictory. On one hand, the government wants you to take the money from your retirement account. But on the other hand, they say, wait, don’t rush, we are giving you this relief from taking required minimum distributions, so you can keep the money in your retirement account for a little longer.
So what should you do? Of course, there is no universal answer and it depends on your unique situation and age. If you lost your job, not working, and not getting any income whatsoever, financially struggling, and has 15-20 years before retirement that’s one thing and taking money from your retirement account is probably not a bad idea at all. But if you are still managing to stay afloat, has some income or financial reserves, and provide for your family basic needs then think of tapping into your retirement accounts as your last resort.
Here’s why: pulling money from your retirement account can turn out to be a real financial disaster as you will likely be selling in a down market and at a substantial discount. Then, chances high you may never return the money back. After recession companies tend to be more cautious: they hire less, be more selective, not that generous when it comes to paying pre-recession salaries or giving pay raises. That was actually what happened after the 2008 financial crisis.
Because of the withdrawal you may also miss on the market recovery which will inevitably happen and forgo power of compounding. Just recall the 2008 financial crisis again when so many people sold their investments and put the money into cash. When the market aggressively bounced back in 2009 but many didn’t participate in that growth and eventually it cost them a lot of money and precious time.
So if you can – find other money sources during this tough time and don’t tap into your retirement accounts.
Now let’s see what some of the money sources you can use before dipping into your retirement plans.
First, you can take a retirement plan loan instead of a withdrawal. The loan limit was doubled from $50,000 to $100,000. Moreover, new and existing loan payments can be deferred for 1 year which will give you some relief from payments. The advantage of a taking loan is that you will have to pay the loan back and will not have to pay taxes. But a retirement plan loan is still far from being the best option. You will still have to sell in a down market and also you can miss the market reversal. You will also be repaying the loan with after-tax money. Later in retirement, you will be taxed again on withdrawals. So you will be paying taxes twice. Another problem may arise if you get laid off with a loan in place. You will be forced to pay it back or having to pay taxes as the loan will be treated as an early distribution.
Second, if you own a property and built enough equity on your home, consider a home equity loan. The home equity loan allows you to borrow money against your home minus the amount of outstanding mortgage. Let’s say your home is worth $300,000 and your outstanding mortgage balance is $200,000 – you can borrow up to $100,000. Home equity loans are a little easier to qualify because your house serves as collateral.
Third, consider a home-equity line of credit, a HELOC. A HELOC is similar to a home equity loan but not the same. With a home equity loan you get cash upfront but with HELOC you get a line of credit that you draw from. The good thing about HELOC is that you get flexibility and control. You can borrow from this line of credit multiple times and take however much you need. You pay interest only on the amount borrowed. If your home value drops significantly, and that can happen if enter a recession, your lender can freeze or cancel the line of credit.
Fourth, if you have cash value life insurance, such as whole life policy, universal life policy, or variable life policy you can then use the cash value as a source of loan or a source of cash. Of course, you need to have cash value built first before you borrow from the policy or the cash, so check with your insurance company. But no matter what, during hard times like this the cash value feature becomes a huge plus and compensate for higher premiums that you pay compared to a regular term life insurance.
Fifth, borrow money from your family or friends. Don’t underestimate this potential source of cash. If someone among your family members or friends is doing better financially than you are, I’m sure they will be more than happy to give a helping hand.
Finally, if you tried everything you could and still need to dip into your retirement accounts, pull the money from the fixed-income portion of your portfolio first. When the market bounces back it is the equities component in your investment portfolio that will be pushing your account value up, not bonds. That’s why it’s important to keep the equity exposure untouched.
Once your financial situation gets better and your income returns, make sure to return the money back so you don’t have to pay income tax and can participate in the market recover even further.