Did Congress Just Give Us A Free Pass To Access Our 401ks?

rogernusbaum

Part of the CARES act recently passed in Congress in reaction to the Coronavirus pandemic is to allow access to 401ks and IRA for people who are not yet 59 1/2. The basic idea of course is that anyone who is in trouble can access their tax advantaged savings in their time of financial need. It is easy to envision a scenario where someone has built up a robust retirement account balance but only has one or two months of bills set aside in an emergency fund. If this person's pay stops for whatever reason then come May 1st or June 1st they are going to need to do something and in that light, tapping their retirement account can help. To someone in that situation, I would say only take out what you need for the next month. If things don't return to normal 30 days later, then take out an other month's worth.

The reason I say to only take out what you need one month at a time is because these withdrawals are taxable. Congress has waived the penalty for people under 59 1/2, which definitely helps, but not the tax consequence. This is not a free lunch. I think people will be creating tax problems for themselves if they take too much out for their expenses or thinking that it is a freebee. You owe the tax on whatever you take out, you have to start paying it back (the tax) starting at the end of 2020 and then you have another two years to get all the tax paid. If you have no other option, then you have no other option and you'll worry about the tax later but if you do have an option then consider that you will have to pay the tax. You can instead repay what you took out, kind of like a rollover, but I'm not so sure that is realistic for too many people who are forced to take money out of their retirement accounts to pay their bills.

The tax issue is so problematic that I believe Congress will change the part about IRA withdrawals in the next package to allow for penalty free and tax free access to retirement accounts. I am saying (guessing) that on the next go around it will become a freebee. And that is where things get more interesting. If they give us free access to these accounts, even if the dollar amount is capped, then we need to consider it, take a close look at our specific situations and make an informed decision.

I am not saying just do it in a blanket fashion, but there are scenarios where it makes sense. Here's a scenario where it does make sense. We've written many posts about the difficulty for people over the age of 50 to replace their income if the face of an unexpected job loss. Are you between 50 and 59 1/2?

Let's say someone is 56, has about enough to retire in their 401k but only one year's worth of expenses in taxable accounts (for now, it doesn't matter whether the taxable money is invested or viewed as an emergency fund). If this person lost their job tomorrow, then a year from now they'd need to start tapping their retirement funds, paying a penalty on whatever they take before 59 1/2 (I am aware of 72t distributions to avoid the penalty but let's just keep it simple for now). If Congress goes ahead and waives the penalty and the tax like I think, then it might make sense to take enough cash out to to fill the gap between when they'd run out of money in their taxable account and when they turn 59 1/2.

There are drawbacks of course like the loss of tax-deferred growth for that slice of the portfolio but it's only a slice, just enough to fill a gap in case something goes wrong; unexpected job loss.

In a similar scenario this can also be a way to manage sequence of return risk. Someone who is two years from their planned retirement with no reasonable visibility of losing their job still needs to think about covering their first couple of years of retirement and make sure that small bit of their portfolio won't drop in value. Whether they've already raised this cash or not, it might make sense to withdraw it from their 401k/IRA now if they can do so without penalty or tax. They're going to need it soon anyway, might as well take it now if, I say if, they can do so without tax or penalty. To be clear, at this point Congress has only waived the penalty.

I am probably a little too far away, age-wise (just turned 54) to do this but will definitely go through the process of assessing whether it makes sense for us if Congress takes the step I think they will take. I am convinced that a lot of people will get themselves into trouble taking withdrawals now that they have to pay the tax on later, I think Congress will recognize this and waive the tax. For now though, as is, I would only suggest taking from a 401k/IRA if there was no other possible option.