Along with the recent Covid-19 inspired stimulus packages is a program from the IRS allowing qualified individuals to access funds from their own 401(k) retirement plans to navigate through this critical period. The headlines were eye-catching and joyfully exclaimed that you can, for a limited time, withdraw from your retirement plan without incurring the 10% penalty. But what does that actually mean? And how is this going to impact our 2020 taxes? It’s important to look at the fine print of the tax code with a qualified CPA to understand whether or not these options are sensible for you.
The standard 401(k) tax code only allows for individuals above the age of 59 ½ to pull money out of their plans without penalty, and pay income taxes based on their current tax bracket. Aside from some short term interest-bearing loan programs, the ability to freely access the funds before that age is very limited. The plans allow individuals to reduce their taxable gross income by allocating portions of their income to grow tax-free (or rather, tax-deferred) until the time of retirement. In an ideal world, the hope is that when we retire (fingers crossed), our income bracket is lower and the applicable federal and state tax rates haven’t risen significantly over the years.
What we’re seeing right now is that for individuals who are qualified under the CARES act, they can pull necessary funds out of their retirement accounts without the 10% penalty while still avoiding payment of taxes. It all sounds exciting because we can just use our own money instead of looking for loans elsewhere. But as with most things, there’s a catch: this is not an interest-free, penalty-free loan for life. Because the funds in a 401(k) are tax-deferred, being able to pull an amount out with no “due date” would effectively be the same as getting paid tax-free income from whatever employer you funded the account through. In actuality, according to the IRS, the bill is giving just a slightly longer than usual grace period for a loan against your 401(k), stipulating that taxes and penalties will not be levied as long as the entire amount is repaid within three years. Beyond that time, any amount not repaid from the loan would be taxed at the normal income level as always.
This all sounds like a great deal except that now we’re loading an additional loan onto individuals in an already cash-strapped economy. Isn’t there still a bit of fear of the unknown hovering over us? Conservatively, we’re probably still looking at a few years of economic volatility. This could include a possible delayed dampening effect on the housing market, a job market will take time to recover, or even the potential of some real fallout from all of those multi-trillion dollar government stimulus funds. This loan program is a great way to open up cash flow for individual households, but it magnifies the need for people to approach it wisely while there are still a lot of question marks about our economic recovery.
The need for these creative monetary solutions is crucial to getting through the next few months while we slowly creep back toward full-time work. The key comes down to this: people must take the time to work with a CPA or accountant who can help determine the tax implications and loan repayment obligations through the lens of each family’s specific situation. With the right advice and preparation, these loan programs should prove to have a significant positive impact over the coming months.
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