The Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed in March 2020 as an emergency response to the economic fallout of the COVID-19 pandemic. Among its many provisions, the CARES Act included temporary changes to the rules governing 401(k) plans and other retirement accounts. These changes allow those financially impacted by the pandemic to expand access to their retirement savings. For many who had their income disrupted or lost entirely, tapping into 401(k) funds may seem like an attractive or even necessary option. However, withdrawing retirement savings now can have significant long-term consequences. It is essential to fully understand the CARES Act’s modifications to 401(k) withdrawal and loan rules before making any decisions.
Table of Contents
1. Historical Context of 401(k) Plans
401(k) plans have been a pillar of retirement savings since the 1980s. Offered by many employers, 401(k)s allow workers to invest pre-tax dollars, which then grow tax-deferred until retirement. These plans empower people to save and invest in their future. While funds cannot normally be accessed before age 59 1⁄2 without incurring penalties, the 401(k) system incentivizes disciplined saving over decades. This helps account holders accumulate assets for a secure retirement. 401(k)s represent a promise to one’s future self. The CARES Act offers temporary relief but should not be seen as undoing the fundamental purpose of these accounts.
2. Why The CARES Act Matters for 401(k) Plans
The COVID-19 pandemic and associated economic crises have significantly disrupted household finances. Widespread job loss, reduced work hours, and increased costs have strained many budgets. Retirement saving has understandably taken a backseat to more immediate needs. The CARES Act 401K withdrawal provisions were introduced to specifically address these concerns, providing a lifeline for those grappling with these unprecedented challenges. It allows qualified individuals to withdraw up to $100,000 from 401(k) or other defined contribution retirement plans before age 59 1⁄2 without paying the 10% early withdrawal penalty.
3. Eligibility Criteria for CARES Act 401(k) Withdrawal
To qualify for penalty-free 401(k) withdrawals under the CARES Act, account holders must meet one of several conditions:
- They have been diagnosed with COVID-19
- Their spouse or dependent has been diagnosed with COVID-19
- They have experienced adverse financial consequences stemming from pandemic-related layoffs, quarantines, reduced work hours, lack of childcare, or other disruptions.
Those seeking to utilize CARES Act 401(k) provisions will need to self-certify that they meet one of these criteria when initiating the withdrawal. This gives account holders flexibility while relying on personal accountability.
4. Tax Implications and the CARES Act
While the 10% early withdrawal penalty is waived, income tax still applies to 401(k) funds accessed through the CARES Act. However, the Act allows for up to three years to pay the taxes owed. Account holders can choose to count the entire withdrawal as income for 2020 or spread it evenly over 2020, 2021, and 2022. This tax flexibility aims to ease the burden in light of the pandemic.
It is important to note that 401(k) funds withdrawn are still subject to mandatory 20% federal withholding at the time of distribution. This is meant to prepay part of the taxes owed, although the funds withheld can be claimed as a credit on tax returns. Account holders need to be aware that they will not receive the full requested distribution amount.
5. How the CARES Act Impacts Loan Provisions in 401(k) Plans
Beyond withdrawal rules, the CARES Act also loosens 401(k) loan restrictions. For 180 days after enactment, the law raised the maximum loan amount to $100,000 from $50,000. It also extended the deadline for repayments on any outstanding loans by one year. This enhanced access aims to help those facing financial hardship due to the pandemic to utilize their 401(k) savings without permanently depleting their accounts.
6. Repaying CARES Act 401(k) Withdrawals
Individuals who take CARES Act 401(k) distributions have up to three years to repay the amount withdrawn to their retirement account. Repaying funds allows the account holder to undo the tax implications of the withdrawal. If the distribution is repaid within this window, taxes paid on the withdrawal can be recovered by filing amended returns.
The ability to repay withdrawn funds presents an opportunity to minimize long-term damage to retirement savings. But the reality is that most people face ongoing financial constraints and are unlikely to replenish their accounts within three years.
7. Impact on Retirement Savings and Future Planning
Early withdrawals from retirement accounts, even under the relaxed CARES Act rules, can significantly reduce the growth potential of 401(k) balances over time. Withdrawing funds now represents lost tax-deferred investment gains later. Those taking distributions must carefully weigh short-term needs with long-term trade-offs.
Younger individuals who withdraw retirement funds have the most to lose, as they forfeit decades of potential tax-deferred compounded returns. However, anyone counting on 401(k) assets to fund their retirement may need to reevaluate their financial plan if they make an early withdrawal.
8. Comparing CARES Act Provisions to Previous Financial Crises
The CARES Act is not the first time the federal government has adjusted 401(k) rules during financial crises. Similar temporary hardship withdrawal and loan provisions were included in legislation responding to Hurricane Katrina in 2005 and the 2008 financial crisis. The pandemic-induced recession, however, has had a far broader and deeper economic impact than past downturns. The need for access to retirement funds is also unprecedented.
9. Important Considerations Before Making a Decision
The CARES Act attempted to strike a prudent balance between providing emergency 401(k) access without excessively undermining retirement security. Those considering a 401(k) withdrawal under the CARES Act provisions should carefully weigh several factors:
First, assess how truly essential the withdrawal amount in question is for near-term financial survival. Funds withdrawn from a retirement account should be limited to the minimum needed to cover urgent priorities. Next, take stock of what other budget adjustments might be possible in the near term. Are there expenses that can be reduced or eliminated?
Also, explore other relief options that may be available other than retirement savings. Research unemployment benefits, lender accommodations, nonprofit assistance funds, and other alternatives. If currently employed, check if the employer offers any emergency hardship provisions.
Conclusion
The CARES Act offered much-needed flexibility for Americans to access retirement funds during the pandemic. However, withdrawing 401(k) savings has significant long-term trade-offs. Workers should carefully consider the short and long-term implications before utilizing CARES Act provisions. With prudent planning, research into alternatives, and disciplined spending, raiding retirement funds may not be necessary.
About Carson Derrow
