Penalties on Early Retirement Withdrawals Suspended: What You Need to Know

Penalties on Early Retirement Withdrawals Suspended: What You Need to Know

At the end of March 2020, President Donald Trump approved a landmark stimulus package designed to provide some relief to individuals economically impacted by COVID-19. This package will keep many people afloat financially during a trying time and creates some unique opportunities for individuals who have been saving for retirement.

The stimulus package includes a one-time payment of $1,200 to qualifying adults and a total of $500 for each dependent child. Another part of the package has been overshadowed by the government payments: the ability to tap into retirement nest eggs without penalty.

What to Know about the Specifics of New Early Withdrawal Rules

Under normal circumstances, individuals must pay a 10-percent penalty whenever they remove funds from an individual retirement accounts (IRA) or 401(k) prior to the age of 59.5. This option will prove extremely beneficial for people who have suddenly lost their jobs or experienced a significant reduction in income.

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However, drawing on a nest egg comes with consequences that need to be considered in advance, especially if the money is not absolutely necessary. Of course, many Americans are currently out of work. While these individuals can apply for unemployment, the weekly benefit is often half or less of their former paycheck. High earners may find the amount almost negligible compared to their usual income.

Prior to this bill, unemployment provided no exemption to the usual penalty on early retirement plan withdrawals. Doing so because of lack of employment would trigger the 10-percent penalty, as well as a tax burden on the entire amount withdrawn, which is how traditional 401(k)s and IRAs work. The bill makes it possible to withdraw up to $100,000 from an IRA or 401(k) without paying the 10-percent penalty.

Furthermore, while people will still need to pay the usual taxes on these withdrawals, they can spread the liability across a three-year period rather than paying them immediately. The rules apply to anyone who has experienced financial loss due to COVID-19, from being laid off to testing positive for the illness.

The Downsides of Making Early Withdrawals

The new rules make it much more feasible for people in crisis to support themselves. However, individuals who can support themselves through another avenue should still avoid early withdrawals. Taking money from a retirement account may seem like a more viable option then getting a loan or exploring other financial options, but the ramifications can prove quite serious.

The biggest consideration is that the market is currently in a bear market because of the health crisis. As a result, most retirement accounts have taken a hit. Withdrawing money from those accounts now means that people lock their losses. If individuals let their accounts sit, they will eventually recover. However, taking a withdrawal and selling off some investments means there is no chance of recovery, so the current losses are permanent.

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The other point to keep in mind is that withdrawing now means less money during retirement. While this may sound obvious, it is important to think about the loss of growth. Money in retirement accounts gets compounded, but it cannot grow once it is removed from the IRA or 401(k).

Taking $20,000 from the account today would actually mean losing out on $152,000 during retirement assuming a 7-percent average annual return over 30 years. This rate of return is reasonable provided that a portfolio relies heavily on stocks. For this reason, people should avoid tapping into retirement accounts whenever possible. This is particularly true for people who will not retire for many years, since compounding is more effective the longer money is invested.

What to Consider before Dipping into Retirement Accounts

Individuals who suddenly have reduced or no income have every right to be anxious about paying their bills. Despite this, it is important to think about other options prior to tapping into a retirement account. Doing so could delay the age of retirement or prevent account holders from reaching other personal goals.

One option is to speak with creditors. Mortgage lenders in particular are sympathetic to the struggles of their customers and may allow a temporary deferment on payments until homeowners can get themselves back on their feet.

People with student loans should speak to their lenders to learn about deferment options. Many lenders are offering penalty-free deferments, and federal loans come with their own benefits that borrowers should investigate. People can also speak to utility companies, many of which are giving leeway in this strange economy. Other options include loans, reverse mortgages, and similar products.

When people do feel the need to dip into their retirement savings accounts, they should know that they can return any of the money they do not end up needing to avoid paying taxes on that amount. People should use only the money they absolutely need to make ends meet.

Additionally, they should not hesitate to replace any of the funds they withdrew but ended up not needing. This will reduce tax liability and help ensure the money has an opportunity to continue growing as retirement approaches. Speaking to a financial professional is the best way to make sure individuals are making the best choice for their current and future financial situations.