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Under almost any circumstance, tapping your retirement plan savings for cash is a bad idea.
Tax professionals and financial advisors will almost universally tell you to use all other sources of liquidity before you hit your tax-advantaged retirement accounts.
“Certain IRAs and qualified plans are protected from creditors,” said Ryan Losi, a CPA at Piascik. “If you’re looking at bankruptcy, the worst thing you can do is take money out of those plans, pay taxes on it and make it available to creditors.”
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But for millions of Americans who have suffered financially as a result of the coronavirus pandemic, retirement plan savings may now be their only source of cash.
Enter the coronavirus-related distribution.
Under favorable terms granted as part of the federal CARES Act passed in late March, eligible individuals can withdraw up to $100,000 — known as a coronavirus-related distribution — from qualified plans, including 401(k) plans and individual retirement accounts.
If you or your spouse contracted Covid-19, lost your job or saw your hours or income reduced due to the pandemic, you’re eligible to make the withdrawal.
The same goes for individuals who were unable to work because the pandemic led to their losing their childcare.
If you have not taken a coronavirus-related distribution from your retirement plan yet, you have until the end of the year to do it.
Allowable under the CARES Act
Normally, withdrawals from these accounts are subject to a 10% penalty if you pull the money before you turn age 59½.
The CARES Act waives this penalty and allows you to spread the income and taxes over the next three years on your tax return.
You don’t have to repay the funds, but if you do within three years — and file amended returns — there is no tax liability for the withdrawal.
The allowable rule changes by the IRS are just that: allowable.
If your plan is to repay the withdrawal in the next three years, ask yourself how confident you are in your ability to do that.
Mark Luscombe
CPA and principal analyst at Wolters Kluwer Tax and Accounting
It is up to employers whether they adjust their plans to allow for the favorable distribution terms, so consult your HR department for your options.
“It always depends on an individual’s particular facts, but we suggest people shouldn’t do this unless they have no other choice,” said CPA Mark Luscombe, a principal analyst for Wolters Kluwer Tax and Accounting.
“If you do take the withdrawal, you should restore it to the plan when you can.”
Repaying funds now vs paying taxes
If you have already taken a coronavirus-related distribution, the issue now is whether you recontribute the funds back to the plan (or another eligible plan), and whether you should pay taxes on the distribution if you don’t put the money back this year.
On the first front, replacing withdrawn funds from tax-deferred savings accounts as quickly as you can is generally a good idea.
The length and costs of the average American’s retirement continue to increase, and you may live to regret spending retirement savings now.
“The quicker you repay it, the quicker it begins earning a return again,” said Luscombe of Wolters Kluwer.
The timing could be better.
Individuals who took distributions earlier this year, missed out, at least to a degree, on one of the strongest recoveries from a bear market in history. People reinvesting withdrawals back into the stock market now will be doing so at much higher valuations.
As for how to account for the distribution and when to pay taxes on it, it depends on your financial circumstances.
If you lost your job or took a hit to income this year, but expect your situation to improve, you can return the funds within the next three years and file an amended return.
This way, you get a refund of the taxes you paid in the years the withdrawal was included in your income.
However, if you ultimately can’t repay the money within three years, you will owe taxes and possible penalties.
“If your plan is to repay the withdrawal in the next three years, ask yourself how confident you are in your ability to do that,” said Luscombe.
He recommends people pay taxes on one-third of the distribution this year.
One year vs three years
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Individuals also have the option to include the entirety of the distribution in their income this year.
If your income has been substantially affected this year and the withdrawal doesn’t bump you into a higher tax bracket, it may make sense to recognize the distribution more rapidly when you’re being taxed at a lower rate.
“In general, we recommend people defer income and taxes, so my preference would be to spread the withdrawal over the three-year period,” said Losi at Piascik.
However, he acknowledges that a “blue wave” of Democrats in presidential and congressional elections next month could result in rate increases across various tax regimes.
While Losi and Luscombe understand that retirement plans may offer the only cash lifeline for many people, they suggest using it as a very last resort and paying tax on at least one third of the distribution this year.
Cut your living expenses, defer payments on your mortgage or student loans, and stop contributions towards other savings goals like 529 college plans before you tap your retirement savings.
“Exhaust all other liquid assets before you do this,” said Losi. “This is the last thing you want to do.”
