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In addition to giving Americans a one-time stimulus payment and paving the way for expanded unemployment benefits, the CARES Act has temporarily changed the rules about withdrawing money from retirement accounts. You can now take penalty-free withdrawals from your IRA or 401(k) up to $100,000 without facing the usual early withdrawal fees.
With unemployment levels still high and millions of workers furloughed or working fewer hours than before, this major rule change could help bring much-needed relief to the increasing number of Americans financially impacted by the COVID-19 crisis. Of course, drawing on retirement funds is something to avoid if possible — but as the government continues to wrestle over the details of and , borrowing from a retirement account may become an appealing option.
The new rules remain in effect until the end of the year. Here’s how to take advantage of them.
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What were the rules before COVID-19?
Prior to the passage of the CARES Act, you couldn’t take money out of your retirement accounts before you were 59 1/2 years of age without getting hit with an “early withdrawal” charge. The 10% tax penalty was put in place to dissuade people from spending money that they should be saving for retirement.
Even though there were some exemptions to the rule — like withdrawals for tuition and other educational expenses or buying a home — Americans were forking out more than $5 billion a year in early withdrawal fees, according to the IRS. To avoid getting hit with the penalty, it’s generally a good idea to leave your retirement account alone until after you’ve stopped working full-time.
What did the CARES Act change?
The CARES Act allows you to withdraw up to $100,000 from your retirement account — penalty-free — until the end of 2020. So far, relatively few Americans have taken advantage of this new exemption: The Investment Company Institute reports that less than 3% of retirement plan owners made early withdrawals so far this year.
Read more: Lost your job? Here’s what to do with your 401(k)
Who qualifies for the exemption?
Only tax-deferred retirement accounts qualify for this exemption, including:
- Employer-provided retirement accounts, like a 401(k) or 403(b) — although other types of plans might qualify
Not everyone is eligible for this exemption, however. You qualify only if:
- You, your spouse or a dependent is/was diagnosed with COVID-19.
- You’re going through major financial hardships due to COVID-19 such as losing your job, a delayed start date for a new job, a job offer that gets rescinded, furlough, a reduction in hours, closing of your business or you can’t work due to lack of childcare.
If you meet the criteria, you have until the end of 2020 to make a qualified distribution of up to $100,000 — per person — without incurring the 10% tax penalty. Keep in mind that although these would be penalty-free withdrawals, you’ll still owe income taxes on them. But you can spread out what you owe over the course of three years.
Good reasons to tap your 401(k) right now
- Money to cover urgent needs: If you need to make a mortgage payment, keep the lights on or pay other bills, you may need to take money out of your retirement plan. If you’re facing eviction, a lien on your home or foreclosure, tapping your 401(k) could make sense.
- Avoid taking out a loan: If you have a high credit score and are eligible for favorable terms, taking out a loan can be a good short-term tactic. But for many people facing long-term unemployment and under-employment, a loan may simply become another impossible bill to pay. Some people don’t qualify for taking out a loan and don’t have any other financial resources aside from borrowing from their retirement plan.
Drawbacks of taking money out of your retirement plan
- Taking money from your future self: The standard advice is to leave your retirement account alone until you’re retired. The earlier you start saving for retirement and the more you can contribute, the more it compounds over time. Any time you take funds out before you need them, you’re taking money away from your future (retired) self. If you can avoid it, you should.
- Tax implications: Even though you’re avoiding the 10% early distribution penalty, you will still be subjected to income taxes on that money. Remember: money deposited into a traditional IRA is taxed when it’s withdrawn — not when it’s contributed. So, however much money you withdraw will be added to your annual income, and you’ll be taxed on that accordingly. That could put you in a different tax bracket and dramatically change how much you owe in taxes.
Read more: 5 investment accounts everyone should have
Source: Cnet News
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