Recent changes to rules regarding early 401(k) withdrawals make it simpler to access retirement funds, blurring the lines between loans and hardship distributions.

If you're in urgent need of funds, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) has relaxed the rules surrounding early withdrawals from your 401(k) or other employer-sponsored plans. But it’s essential to grasp these new regulations before making any withdrawals.

Jeanne Fisher, a CFP and managing director, warns against the potential pitfalls of 401(k) withdrawals. “The first loan isn’t the problem; it’s the habit that can form,” she explains. “You don’t want to make a practice of using your retirement account as a quick loan.”

However, the current environment offers some of the best terms for early 401(k) withdrawals:

  • The 10% penalty for early withdrawals related to coronavirus is waived for distributions made in 2020 for those under 59 ½.
  • You can now withdraw up to $100,000 or 100% of your vested balance, up from the previous $50,000 limit.
  • The usual 20% federal tax withholding on distributions has been suspended, allowing you to receive the full amount from your withdrawal.
  • Hardship withdrawals are now structured more favorably, resembling loans rather than permanent deductions from your retirement savings.
  • In certain situations, you can avoid paying income taxes on an early withdrawal altogether, essentially giving you a three-year, interest-free loan.

Before checking your balance, remember that all the risks associated with early withdrawals remain. Cashing out now locks in losses at an inopportune time, preventing you from benefiting from compound interest and potentially missing out on market recoveries.

If you find it absolutely necessary to withdraw, consider these steps to reduce the financial impact:

Why a 401(k) Loan is Preferable

Here’s why opting for a 401(k) loan may be a better choice than a hardship withdrawal:

  • With a loan, your retirement savings only face a temporary setback, as you will repay the borrowed amount with interest. In contrast, a hardship withdrawal does not require repayment, and IRS rules may prevent you from returning the withdrawn amount to your account once normal regulations resume.
  • The CARES Act extends the repayment period for loans taken in 2020 by one year, giving you a total of six years to pay it back. It also extends the repayment deadline for existing loans by an additional year.
  • You have a year from the loan origination date before you must begin repayments, allowing for some breathing room. For those with existing loans, payments due from March 27 through the end of the year can be suspended (though interest and fees will still accrue during this time).
  • You’ll only incur taxes if you default on the loan, such as losing your job. The CARES Act allows you to spread out any taxes owed over three years.

If you’re faced with the choice of a hardship distribution versus a loan, Fisher advises opting for the loan. “Sticking to a repayment schedule is beneficial because you’ll repay yourself, helping you avoid taxes and penalties if done correctly,” she states. But first…

Do you qualify? The relaxed rules apply only to those impacted by the coronavirus pandemic. To qualify, you or a family member must have been diagnosed with COVID-19 or faced financial difficulties due to quarantine, furlough, job loss, or reduced income.

Does your plan allow loans? Not every workplace retirement plan permits 401(k) loans, and they are not required to adopt the new CARES Act rules. According to Fisher, most plans that didn’t allow loans prior to the pandemic are unlikely to introduce them now. Larger plans are more likely to feature loan provisions; research shows that 90% of plans with 1,000 or more participants offer loans, compared to just 30% for plans with 10 or fewer participants.

However, many plan administrators are adopting the new hardship withdrawal rules.

What Constitutes a 401(k) Hardship Distribution?

A 401(k) hardship distribution allows employees to withdraw funds without having to replace the amount. Fisher emphasizes, “This approach is more detrimental than a loan because you’re actually removing essential funds without any obligation to reinvest.”

The IRS defines a hardship as a pressing financial need. Qualifying expenses include:

  • Medical costs
  • Costs associated with buying a primary home
  • Tuition and related educational expenses
  • Payments to avert eviction or foreclosure
  • Funeral expenses
  • Qualified repairs to a primary residence
  • Under the CARES Act, financial hardships due to the pandemic also qualify for distributions.

The CARES Act has made significant changes to hardship withdrawals:

  • Hardship withdrawals are no longer permanent, allowing individuals to repay funds withdrawn. If repaid within three years, individuals can reclaim any income taxes paid.
  • While traditional IRS rules limit withdrawals to only what is necessary, the CARES Act raises the cap to $100,000 or your total vested amount, whichever is less.
  • The 10% penalty for early hardship withdrawals is waived, and the mandatory 20% upfront withholding for taxes is temporarily suspended.
  • Ordinary income taxes still apply for those under 59 ½, but these can be spread out over three years.

Fisher notes that this resembles a loan-like option for plans that don’t allow loans, though questions remain about how repayments will be managed. Clarify your plan’s rules to avoid unexpected costs.

Important Considerations Before Accessing Your Retirement Funds

Before tapping into your retirement savings, explore other options, such as emergency savings, securing a personal loan, using low-interest credit cards, or withdrawing from a Roth IRA.

If you still face financial challenges and must proceed with a 401(k) loan or hardship withdrawal, keep these six points in mind:

  • The $100,000 limit on early distributions is a per-person cap, not per account.
  • The additional year to repay loans does not include interest or fees, which will continue to accumulate.
  • You may not have the option to choose which investments to liquidate (e.g., cash versus stocks), depending on your plan.
  • Your future tax obligations could be substantial since the CARES Act merely postpones the mandatory withholding, meaning you’ll owe taxes later. Prepare to set aside funds for your tax bill.
  • If you leave your employer, the outstanding loan balance becomes due sooner, requiring payment by the tax deadline of the following year. Failing to pay incurs income taxes on the remaining balance.
  • Finally, if bankruptcy is a possibility, it’s wise to keep your funds in a 401(k) where they remain protected from creditors.