Spending Retirement Money When You're Not Retired

We’re almost five months into the aftermath of the coronavirus stay-at-home orders and our economic recovery is uneven at best. Some companies have been doing extremely well and their stock prices are up a ton due to having some sort of pandemic narrative (more people streaming Netflix, buying from Amazon, and so forth). This can absolutely continue so long as hopes of further economic stimulus remain.

Some individuals are doing fine, all things considered, in their work and financial lives. Others are retired and work issues are less relevant. But for others the work problems and financial woes are just beginning.

We’re all familiar with the many small retail-oriented businesses that have permanently closed following the confusion of temporary shutdowns. Recent data from Yelp lists California as having the third highest amount of permanent and temporary business closures per capita in the US (behind Hawaii and Nevada, I think). Many of these closures have been within the Bay Area, even our own county. Each of us probably knows at least one person whose financial life has been thrown into shutdown-induced chaos.

But lately I’ve been hearing from folks who had been feeling insulated from much of this. They’re not in retail or the restaurant business but nonetheless are finding themselves facing reduced hours or even an outright layoff. They’ve been mid- or late-career professionals who have saved money but not enough to pull the trigger on early retirement. They have young kids or are getting their kids through college. They’ll soon need cash but the only buckets they can draw from are their retirement accounts. They’re worried about taxes and penalties, not to mention needing to spend “future dollars” for current needs.

So, the following are some thoughts and rule changes related to drawing money from retirement accounts when you’re younger than 59.5 (an important cutoff for the IRS).

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The recently passed CARES Act broadened the rules that cover pulling money from your 401(k) or IRA. If you or a family member contracted Covid-19 or are otherwise economically harmed by the pandemic (which is the whole point of this post), you can self-certify to that and the details below would apply.

You typically have two options for accessing cash from a workplace plan: a loan or a hardship distribution. In either case you’ll be limited to your “vested” balance up to $100,000. It’s possible that your employer doesn’t allow hardship distributions, just loans, so you’ll want to check with your HR folks about that.

Loans wouldn’t be taxed, and you can delay making payments for up to a year. And since it’s a loan from yourself, so to speak, you’ll be paying back your retirement account. So that’s forced saving which is good if you can afford it.

Taking a loan works if you’ll be staying with the company. If not, any outstanding loan balance converts to a taxable distribution unless you can repay it in full. This has been the standard for years, but it seems unnecessarily punitive given the circumstances. I’ve read the pertinent sections of the bill and am not aware that the CARES Act addressed this problem. This could be one of those issues that gets fixed by Congress later, but it’s a risk to take a loan if you feel your job is shaky.

Hardship distributions from your workplace plan are taxed as income but the typical 10% penalty for an early withdrawal is waived. The 20% mandatory tax withholding is also waived, so you’ll get to use your full distribution until it’s time to file your taxes.

The tax issue gets complicated, so you’ll want to be careful and think ahead. The CARES Act automatically spreads the taxable amount over three years instead of forcing you to lump it all into 2020. This sounds good superficially but may not be beneficial if your income is low now and you expect it to go back up next year.

Additionally, should your income situation change for the better, you have three years to put some or all the money back into a retirement account. Doing so offsets the taxes on the dollars you put back, so you’d plan to file an amended tax return to get a partial refund.

Most of the above applies to IRAs except that you can’t take loans, only distributions. These would be taxable in the same way and have the same limit of $100,000 penalty-free.

That’s for IRAs. Taking cash from Roth IRAs is a little simpler. Since your Roth money wasn’t tax deductible originally, if you’ve had the account open for at least five years your distribution won’t be taxed. This seems like a no-brainer for accessing cash in an emergency. However, tax-free Roth distributions are best saved for when your taxable income is higher, or at least normal. For now, it may be better to leave your Roth alone and spread taxable distributions over three years.

As I alluded to above, doing any of this means spending future money today and will make it that much harder to save for retirement. As a financial planner I usually try to have folks pursue other options for finding cash, but sometimes hitting up your retirement accounts is the best way to keep you and your family afloat during an emergency.

Also, the above is general information and shouldn’t be taken as tax advice. Your individual situation is far too complicated for simple answers, so you’ll need to consult an appropriate tax professional.

Have questions? Ask me. I can help.