The CARES Act has made borrowing from a 401(k) more appealing if you're in urgent need of funds. However, tapping into your retirement savings comes with its own set of consequences.

The COVID-19 pandemic has resulted in widespread job losses and income disruptions. Many are struggling to cover essential expenses like housing and groceries.

In normal circumstances, financial experts typically advise against taking loans from your 401(k) or 403(b). But for countless individuals facing dire situations, a 401(k) loan could be a viable solution after exhausting other resources.

Here's what you should know regarding 401(k) loans and withdrawals from your retirement savings.

Defining a 401(k) Loan

A 401(k) loan is essentially money borrowed from your employer-sponsored retirement plan. You're borrowing against your future savings. While you will incur interest and possibly fees, the principal amount is taken from your account.

Loan terms can differ based on your plan's stipulations, but generally, borrowers get up to five years to repay the amount plus interest. If repayments aren't made on time, the remaining balance is classified as a distribution, leading to income tax liabilities and a possible 10% early withdrawal penalty.

Before the pandemic, you could borrow up to $50,000 or 50% of your vested balance, whichever was less. However, the CARES Act has introduced changes to these rules.

Impact of the Pandemic on 401(k) Loans

The CARES Act, enacted recently, allows you to borrow up to $100,000 from your 401(k) or 403(b), or 100% of your account balance, whichever is lower.

Additionally, borrowers can postpone loan repayments for a year, extending the payback period to six years instead of five. This extension also applies to any existing loans, but be sure to consult your plan administrator before delaying repayments.

Note that interest will continue to accumulate during this deferral period. However, you won't incur income tax on the borrowed amount if you repay it within the specified timeframe.

Understanding 401(k) Withdrawals

A 401(k) withdrawal means cashing out part of your retirement savings without an intention to repay. Previously, if you withdrew funds before age 59½, you faced a 10% penalty in addition to income taxes.

Under the CARES Act, the 10% penalty is waived for hardship withdrawals, allowing those under 59½ to access their funds without the extra tax burden. You also have three years to settle any taxes owed from the withdrawal, and if you replenish your account within that timeframe, you can recoup the taxes paid.

However, if you consider withdrawing funds, it's better to use your Roth IRA first.

Disadvantages of Borrowing from Your 401(k)

Generally, borrowing against your future savings is not advisable. Here are the reasons:

  • Lost Earnings: Even when you repay the loan, the funds you borrowed miss out on potential growth during that period.
  • Early Repayment Risk: If you leave your job or are terminated, you might have to repay your loan by the next tax deadline. For example, if you took a loan and then lost your job, you'd need to pay it back by the July 15 deadline.
  • After-Tax Repayment: Repayments are made with after-tax dollars, which means you'll be taxed again when you withdraw those funds later.
  • Potential Penalties: If you fail to repay, the loan is treated as an early distribution, incurring a 10% penalty.

Exploring Alternatives to 401(k) Loans

If you're hesitant about taking a loan from your 401(k), consider these alternatives:

  • Pause Contributions: Instead of contributing, consider halting your 401(k) contributions temporarily to keep more cash on hand.
  • Hardship Distribution: Take advantage of the CARES Act, which allows penalty-free hardship withdrawals for those under 59½.
  • Alternative Loan Options: A personal loan can be a better option, as it does not draw from your retirement savings. Home equity loans or lines of credit (HELOC) might offer lower interest rates and longer repayment terms but involve borrowing against your home.

Are the New Rules Applicable to You?

Before making any decisions, check whether your employer has implemented the CARES Act provisions in your 401(k) or 403(b) plan. Some plans may limit the number of outstanding loans a participant can have. Employers also have the authority to modify the rules as they see fit.

Borrowers need to demonstrate eligibility for loans under the new provisions, showing that they or a family member have been affected by COVID-19 or are facing financial difficulties related to the pandemic.