In times of economic uncertainty, you might start to notice some alarming changes to your retirement account. It's usually unwise to panic and withdraw early, even if the temptation is strong.
• If you’re under the age of 59.5 when you withdraw money from your IRA or 401(k), you will likely pay a 10% penalty on the withdrawal and you will have to include those funds in your state and federal income when you file your taxes.
• Typically, money you withdraw from a Roth IRA during retirement isn’t taxed and is free from penalty. However, if you converted a traditional IRA to a Roth IRA less than five years ago, you can be taxed and penalized when you withdraw that money.
• A 401(k) loan can be a good source of cash for the short term. This kind of loan isn’t taxable now and it won’t cause you to pay more taxes in retirement, provided you meet the repayment rules.
You have options
Are you beginning to notice drastic changes to your retirement account savings? Many have, and some are beginning to panic and withdraw money early without fully considering the tax and financial implications. Resist that urge. When it comes to taxes now and taxes in retirement, we've got the scoop on what you can consider and what you should avoid.
Early 401(k) or IRA withdrawals
The newly enacted economic stimulus package allows those negatively affected by COVID-19 to borrow up to $100,000 from their 401(k) and IRAs without penalty. It also allows the borrower to pay the taxes on that withdrawal over three years rather than all at once.
- If you, your spouse or a dependent has been diagnosed with COVID-19, this "free pass" and "tax extension" applies to you.
- It can also apply to those who are facing financial hardship due to the pandemic. If you're in this group and need to make the withdrawal, then you should definitely consider this to be an option.
However, if you don't fall into the aforementioned group and are under the age of 59.5, withdrawing money from your IRA or 401(k) will likely cost you a 10% penalty. On top of that penalty, you have to pay taxes on all the contributions and gains that you withdraw.
For example, if you took a $50,000 early withdrawal, it would immediately cost you a $5,000 penalty on your federal taxes, and you still have to include it in your state and federal income when you file your taxes. It usually doesn't make good financial sense.
Early Roth IRA withdrawals
Generally, the money that you've contributed to a Roth IRA can be taken out at any time. This money isn't taxed and is typically free from penalty. If you need cash right now, withdrawing the money you've contributed might be a good option for you.
However, be aware that if you make an unqualified withdrawal from your Roth IRA that has been earned through investments, then you would likely pay taxes and penalties on that money. Additionally, if the money in your Roth IRA was converted from a traditional IRA, you can be taxed and penalized on withdrawing that money if the conversion happened less than five years ago.
TurboTax Tip: Stopping your current 401(k) contributions can cost you in the long run. Not only will you have less money available when you retire, but you might also miss out on any employer-matching 401(k) contributions you would normally receive.
If you need cash now and know that you can pay it back, then taking a loan from your 401(k) might be a good choice for you. The CARES Act has increased the maximum loan amount to $100,000 and delays the payment on existing loans. As long as you meet the repayment rules, this type of loan isn't taxable now, nor will it cause you to pay more in taxes in retirement.
Additionally, if you repay the loan on schedule, it will have little effect on your retirement savings overall. Since you'll be repaying a 401(k) loan with after-tax dollars, some of the loan amount will be lost to income taxes, but this is typically a small amount, especially when compared to other types of loans, such as bank and personal loans.
Stopping 401(k) payments
Like withdrawing early, you might be tempted to put a temporary stop on your current 401(k) contributions. Even if you could use that money elsewhere, you're taking money out of your pocket from the long-term to deal with a short-term situation — especially if you're going to be missing out on employer-matching contributions.
If you need more cash now, it would likely be better to take a loan from your 401(k) rather than to stop payments entirely.
If watching your retirement savings numbers go down is making you feel like you need to get out by selling stocks before it gets worse, think again. Generally, the stock market rises and falls like the ocean current, so even though we might be at low tide, just remember that your money will likely come back as our country rebounds.
What financial advisers learned from the 2008 stock market crash is that investors who kept their money in the diversified portion of their portfolios (stock mutual funds) did better than those who sold. This is because it's next to impossible for the average investor to predict the best days to sell and the best days to buy. It's often better to leave the money in the mutual funds and wait for the market to make its rebound.
This may seem like a strange idea to some, but because the market usually rebounds, this could be a great time to buy stocks. Basically, stocks might be on sale right now, so if you have the money to invest, it could be profitable.
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