Why A Distribution From Your Retirement Plan Should Be The Option Of Last Resort

It’s a scary time out there and with at least another month of stay at home orders, Americans are looking at their personal finances. Some are hoping that the stimulus checks will be a lifeline while others are focused on accessing the expanded unemployment benefits. But for those finding that their financial picture is getting bleak, there is another lever they can pull to access liquidity:  their retirement accounts.

To be clear, a fundamental tenet in financial planning is that it is generally not a good idea to take early withdrawals from your retirement accounts. The U.S. retirement system has moved almost entirely to a platform where the onus is on the individual to save.  Due to the higher cost of living and the impact of longevity, most Americans aren’t saving enough.

But these are not normal times, and many of us are simply trying to survive. As a result, it is important to understand the recent changes that were made in the CARES Act to allow for easier access. Even with these new expanded rules, however, this really should be the option of last resort.

What Has Changed

Prior to the CARES Act, in most cases if you took an early distribution from a retirement plan, you were subject to a 10% penalty in addition to the federal and state taxes due if you were under age 59 ½. The new CARES Act has changed this very important rule on how you can take a distribution. Under the CARES Act, the 10% penalty is waived if it is a corona virus related distribution of up to $100,000 made in 2020.

But you need to focus on the details. In order to take advantage of this, you need to look to the new law to understand how a coronavirus-related distribution is defined. Luckily Congress made the definition very broad to include every American. To be eligible to take this distribution, you or your spouse or dependent must have been diagnosed with the coronavirus or have experienced adverse financial consequences because you have been quarantined, furloughed, laid off or had a reduction in hours.

Congress went even further to provide relief. They also included individuals who are unable to work due to lack of childcare due to the virus as well as those who own or operate a business that had to close due to the virus.

Further, Congress included another benefit. With normal distributions, you need to pay the federal and state tax in the year of distribution; it is different with CARES Act distributions. You can pay the tax pro-rated over three years, starting in 2020.

Is It the Right Planning?

The fundamental question is whether we should be accessing our retirement funds in order to survive the financial burdens of the coronavirus pandemic. Times are tough. For Americans who are in desperate need of liquidity, it could be the right answer. But there are important issues to think through:

• Investment considerations – Your retirement plan has likely been hit by the severe market volatility and your balance may have dropped by as much as 30%. By taking a distribution, you are locking in what is now simply a paper loss. You may be better served by waiting it out to let your portfolio recover.
• Taxes – If you take a distribution, you are agreeing to pay taxes on the funds. Even though the taxes are spread out, you will need to make sure you are earmarking funds to cover this tax bill. You don’t want to put yourself in a precarious tax position down the line.

Note: If the distribution is paid back within three years, it will not be taxed. Instead, it will be treated like a rollover.

• Unintended consequences – The distribution could create the unintended consequence of bumping you into a higher tax bracket.
• Alternatives – There are other ways to generate liquidity, including taking a loan from family or friends to help float you through this crisis. Across the country, many are coming together to help each other. If you take a distribution, it is like starting back at square one for retirement.

The Last Resort

Ultimately, if you get to the point where you feel taking a distribution is necessary, it is important for you to engage your tax professional. They will be able to point out the pitfalls and projected liabilities that will come with taking this course of action.

While these adjusted rules address a way to handle the current crisis, for most Americans, taking a distribution is probably not going to be the best financial planning decision. In truth, it should be the option of last resort, but for many, it’s helpful just knowing it is there as a backstop.

This article was written by Megan Gorman from Forbes and was legally licensed by AdvisorStream through the NewsCred publisher network.