The CARES Act and 401(k) Withdrawals

When the COVID-19 pandemic took the world by surprise, the ripple effects were felt far and wide. Economic uncertainty forced many people to face financial hardship and, as a result, many looked to their retirement savings for solutions. At the time, the US government enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act as a lifeline to its citizens.

One notable feature within the CARES Act allowed for penalty-free 401(k) withdrawals in some circumstances, marking a departure from traditional rules around early distributions. In this article, we’ll explore everything you need to know about the CARES Act and the coronavirus-related distributions from your 401(k).

What is the CARES Act?

In March 2020, the US government responded to the COVID-19 crisis by passing the CARES Act. The Act, valued at $2.2 trillion, was the largest economic stimulus bill in the history of the United States. Its purpose was to provide financial relief to Americans grappling with the economic fallout from the coronavirus pandemic.

One key provision of the Act that created a substantial ripple in retirement planning was the penalty-free 401(k) withdrawal provision. The usual rules state that taxpayers can only take penalty-free withdrawals from their 401(k) after reaching 59½, or else they’d face both income taxes and early withdrawal penalties of 10% on any amounts distributed.

The CARES Act changed this by allowing people to withdraw up to $100,000 from their retirement accounts, like 401(k)s and IRAs, without the early withdrawal (or “cash out“) penalty. To be eligible, individuals had to meet specified criteria to show the pandemic had caused them adverse financial consequences.

Typically, when you withdraw from your 401(k) plan, the funds would count toward your taxable income for that calendar year. Under the CARES Act, coronavirus-related distributions could be spread over a three-year period so as to smooth the income tax liability to the IRS.

The CARES Act also changed the rules around Required Minimum Distributions (RMDs) suspending them for qualified retirement plans and IRAs. This was done to alleviate some of the financial pressure caused by the pandemic’s onset.

Overall, the CARES Act offered financial relief to many who were economically affected by the pandemic.

Who is Eligible for Penalty-Free 401(k) Withdrawals?

The CARES Act ensured that the penalty-free withdrawals weren’t a free-for-all; there were specific eligibility criteria to meet. Individuals had to demonstrate that the COVID-19 pandemic adversely impacted them to qualify for these special penalty-free withdrawals.

Some criteria that individuals had to meet for coronavirus-related distributions were the following:

• Getting diagnosed with the virus by a CDC-approved test.
• Having a spouse or dependents who were diagnosed with the virus.
• Experiencing financial hardship due to the pandemic due to being laid off, having reduced work hours, being unable to work due to lack of childcare, or closing or reducing hours of a business owned or operated by the individual due to COVID-19.

401(k) vs. IRA Withdrawals

The CARES Act allowed for early withdrawals for employer-sponsored retirement accounts like 401(k)s and certain individual retirement plans like IRAs. Specifically, the CARES Act allowed for penalty-free withdrawals for those affected by the pandemic.

Traditionally, both pre-tax 401(k) and Individual Retirement Account (IRA) withdrawals before the age of 59½ come with a 10% early withdrawal penalty — along with being subject to income tax.

How Much Can You Withdraw from Your 401(k) Under the CARES Act?

Under the provisions of the CARES Act, eligible individuals could withdraw up to $100,000 from their 401(k) accounts in 2020 without incurring the 10% early withdrawal penalty. This limit was significantly higher than what the standard rules allowed. However, it’s essential to remember that these withdrawals, while not penalized, were still subject to income tax.

The Act also provided favorable tax treatment for these early distributions. Instead of paying the tax due entirely in the year of the withdrawal, the CARES Act allowed individuals to spread the tax liability over a three-year period from 2020 to 2022 (reported on annual tax returns).

Furthermore, if the withdrawn amount was repaid to the plan within three years, the individual could claim that the initial withdrawal was actually a tax-exempt rollover.

Should You Take a Penalty-Free 401(k) Withdrawal?

Even though the CARES Act allowed for penalty-free 401(k) withdrawals up to a certain amount, the decision to make such a withdrawal now should not be taken lightly. Taking out money from your retirement account means less money growing for your future. While tapping your retirement early might solve a short-term problem, it could potentially create a more significant issue down the line.

Before taking a 401(k) withdrawal, explore all your options. Personal loans, insurance policies, or even help from family and friends might be viable alternatives. So, you’ll still reduce your retirement savings and incur a tax liability even if you qualify for a penalty waiver in 2023.

Note that CARES Act withdrawals had to be made by December 30th, 2020, so this option has since expired. You’re still eligible to make an early withdrawal from your 401(k), but be prepared to pay both income tax and an early withdrawal penalty.

How to Take a Penalty-Free 401(k) Withdrawal

If you’ve explored all your other options and decided that a penalty-free 401(k) withdrawal is your best choice, it’s essential to understand the process. Here are the steps involved:

1. Contact your plan administrator: Every 401(k) plan has a plan administrator. Usually, it’s either the company you work for or a financial institution. Reach out to them and explain your situation.
2. Complete the necessary paperwork: You’ll need to complete various forms to request the withdrawal and to demonstrate your eligibility for a penalty-free distribution.
3. Pay attention to tax implications: Unless you qualify for one of the very limited penalty waivers in 2023, you’ll be on the hook for both income tax and an early withdrawal penalty assessed on the entire amount withdrawn.
4. Consider the timing: Depending on your 401(k) plan rules and your personal circumstances, the timeline for receiving the funds can vary. Be sure to factor this into your decision.

Alternatives to a 401(k) Withdrawal

There are other avenues to explore when looking for financial relief outside of taking retirement plan loans.

Let’s explore some other ways you can access funds:

1. Personal Loans: Depending on your credit history, personal loans can be a feasible option to meet your immediate financial needs. However, interest rates can be high, especially if your credit score is less than stellar.
2. Home Equity Loans: If you’re a homeowner with some equity in your home, you may consider a home equity loan or a home equity line of credit (HELOC). Be cautious, though, as defaulting on these loan repayments could lead to foreclosure.
3. Borrowing from Life Insurance: Some life insurance policies allow you to borrow a portion of the policy’s cash value. This option could be viable, but it could reduce your death benefit if the loan isn’t repaid.
4. 401(k) Loan: Sometimes, your 401(k) plan may allow you to borrow from your account balance. The loan limit is generally up to 50% of your vested balance or $50,000, whichever is less.
   • But remember, it’s still a loan and must be repaid with interest. This option features many downsides of retirement withdrawals in that your retirement funds won’t benefit from compound growth when they aren’t invested.
5. IRA Rollover: Depending on your situation, you might consider rolling over your 401(k) to a traditional IRA. IRAs can offer more flexibility with regard to investment options and withdrawals, but they also come with their own rules and potential disadvantages.

Whatever option you choose, always consider the long-term impact on your retirement savings. Working with a financial advisor or CPA can help in deciding which path is ultimately right for you.

In Summary

The CARES Act, with its provision for penalty-free 401(k) withdrawals, provided many Americans a lifeline during a challenging economic period. While such a provision offered immediate financial relief, it’s crucial to remember the long-term effects that such withdrawals can have on your retirement savings. The key is to fully understand your options before making a decision that could impact your financial future.

With the array of choices available, having a guide can make all the difference. Capitalize can be your trusted partner when you want to take control of your retirement savings – we help you find your old retirement accounts and manage the rollover process.

Learn more about how we can help you set up your financial success today.