Thinking About Withdrawing From Your 401(k)? Read This First

• Author: Michael Bordonada
• Posted: 2024-08-08

If you read finance news regularly, chances are that you've seen some of the various provision of the CARES Act. As a refresher, this was the first and only stimulus bill that both the House and the Senate passed for COVID-19 issues.

With the goal of ameliorating economic woes to avoid a full economic depression, this bill had several major provisions. For example, it added $600 to each unemployed person's weekly payment for a period of time, it created the Paycheck Protection Program to keep businesses alive, and it allocated money to provide for free COVID-19 testing.

However, there was one surprise tax benefit that sounds great on the surface. It has many people going out of their way to withdraw immediately from retirement accounts. However, it's not worth it for the vast majority of people. Here's why.

The Eligible Types of Accounts

The provision we're discussing in this article covers what the IRS classifies as "retirement accounts". It covers both pre-tax and post-tax retirement accounts. For workplace accounts, this means 401(k) plans for private employees and 403(b) plans for public employees. It also means traditional IRAs, SEP IRAs, and Roth IRAs.

As you likely recall, there's a major taxation difference among these. Roth IRAs are post-tax accounts, which means that you pay all federal, state, and local income taxes on it before you can put money into the account. However, as your money grows over time, you will not face state or federal capital gains taxes on these accounts. Once it comes time to remove money, you'll get every penny.

All other accounts listed are pre-tax. While you still pay FICA taxes, or Social Security and Medicare dues, you do not pay standard federal, state, and local income taxes. While it's more beneficial to contribute to Roth IRAs if you are earning less than you believe you will be earning in the future, pre-tax accounts are great for avoiding the higher federal and state tax brackets. Keep in mind, though, that you will need to pay federal, state, and local income tax for wherever you live at the time you withdraw money from these.

The CARES Act Penalty Waiver

Every tax-advantaged retirement account has two forms of withdrawals, called "qualified" and "non-qualified". If a withdrawal is qualified, that means that all criteria for withdrawal have been met. Typically, this means that the individual is a certain age; if someone takes out money and follows all IRS rules, there is no penalty.

However, there are plenty of circumstances where people withdraw money from retirement accounts early. There are exceptions to the penalty that is incurred, but they typically involve a hefty amount of paperwork and are very specific. This penalty is a 10% fee paid to the IRS in addition to whatever income taxes you might be required to pay upon withdrawal. If you live in New York City and are at the highest tax bracket, that means you would be paying a whopping 72% of your money in taxes and fees!

The CARES Act widely broadened the criteria for qualified retirement account withdrawals. Now, individuals whose income was substantially affected due to the COVID-19 pandemic can make penalty-free withdrawals. Note that this only applies for balances of up to $100,000. Sounds great, right? While it's a lifesaver if you're in a temporary crunch, it is by far not the best path to take.

The Pitfall

Though you'll avoid the IRS's 10% penalty if you withdraw for COVID-related reasons for which the IRS has given exceptions, as long as it's by the end of the 2020 calendar year, there are some major pitfalls that aren't well-advertised.

For example, many blogs state that you will not owe income tax back on IRAs if you withdraw money from them. This is simply not true. You are also expected to treat your withdrawal as a loan. You're given three years to pay yourself back, though this "loan" to yourself can usually be forgiven.

However, you may not be able to forgive yourself for taking it out! Though markets are volatile, you will lose all momentum your accounts may have had. There will be turbulence, but you're killing chances of significant account growth by taking this offer.

In short, if you absolutely need the money right now, your basic needs come first. However, if you have a choice, you should look elsewhere.