Part of Congress’ response to COVID-19’s economic impact has been to eliminate the 10% penalty when those under 59-1/2 withdraw funds from retirement accounts. Contributions to and earnings on these “qualified accounts” are income tax deferred, making them excellent vehicles for saving for retirement. When you contribute to your IRA or 401(k), that contribution is subtracted from your taxable income—sweet! And as long as you leave the money in this qualified account, you won’t pay taxes on either increases in value or investment income. In this way, the federal government encourages us to do what is in our own best interest—save for retirement, a time in our lives when we won’t be earning an income. And, because delaying gratification is hard, to further incent us not to change our minds about those retirement savings, withdrawing funds from a 401(k) or IRA before reaching age 59-1/2 would normally trigger a 10% penalty in addition to the withdrawal being taxed as income—ouch!
But now, if COVID-19 has made you or your family sick or caused you economic distress, you can withdraw from your 401(k) or IRA without paying a 10% penalty, even if you’re younger than 59-1/2. (Note—I’m only talking about traditional IRAs here. The withdrawal of contributions from Roth IRAs, to which you contribute money that has already been taxed, have always been penalty and income tax free.) Congress made this exception so that in this extraordinarily difficult time people can access their retirement savings. But the fact that they created this exception doesn’t mean that taking advantage of it will be good for you. Here are three reasons why raiding your retirement account is a bad idea, even without the 10% penalty:
1. Empathize with your future self
Present self—meet future self. I can remember when I was a kid trying to imagine what the world would look like at the turn of the century when I would be 42. I couldn’t do it. We aren’t very good at imagining our future selves and are even less likely to care deeply about them. But if you don’t look out for future you, who will? The day will most likely come when you will be unwilling or unable to continue to work. By putting away a little in a retirement account now, you can secure your standard of living in that far away (or not so far away) future. A small price for present self reaps a large benefit for future self. Still, it can be hard to forego the pleasure of spending today for some nebulous future self who wants to retire. So once you’ve done the heavy-lifting to get money into your retirement account, don’t shoot yourself in the foot by taking it back out!
You may be thinking “oh, but I have three years to pay it back”, and that is true for these special COVID-19 withdrawals. But what makes you think it’ll be easier (or even possible) to pay it back later than it is to just leave it alone today? The historical data says the people don’t pay back money they’ve borrowed or withdrawn from retirement accounts. Once it has been spent, it is forgotten. And you will miss it when you’re older and have a lot fewer options than you do right now.
2. The Golden Rule of Investing
Remember that we should always buy low and sell high? By cashing in your retirement funds, you’re turning this golden rule on its head. The market is down and so is the value of the long term stock investments in your retirement account. Right now that is a paper loss only, nothing to lose sleep over. Leave it alone and over time the market and your investments will recover and then continue to grow. If you take a withdrawal, you will sell low and turn your paper loss into a real loss. By taking a real loss and moving the money out of your retirement account, there is no way for that investment to ever recover.
3. Then there are the taxes
You will owe taxes on the money you withdraw. The 10% penalty is waived, but withdrawals from retirement accounts are still considered taxable income. If you’re in the 22% income tax bracket, you’ll owe $220 on a $1,000 withdrawal. (Note: Your tax bill will vary; your income determines your tax bracket.) Congress has created another break for people who go ahead and withdraw money from retirement accounts. Instead of including the entire withdrawal in your 2020 taxable income, you can split it over three years. As a result, in our example you could pay $73.33 in extra taxes with your 2020, 2021 and 2022 tax returns instead of paying the entire $220 when you file for 2020. But you will have to pay it—the entire $1,000 isn’t yours to keep.
And, to get you even more cash quickly, Congress has waived mandatory withholding on the COVID-19 withdrawals from retirement accounts. In non-COVID times, if you requested a $1,000 withdrawal from your retirement plan, the plan sponsor would withhold 20% ($200) to pay the taxes you likely would end up owing. Not now—today you can have the whole $1,000. But you still have to come up with the $220 at tax time (or $73.33 for the next three tax times). In the years I spent preparing income tax returns, I never met a filer who was happy to get a tax bill. In fact, most of the people who owed were surprised by the bill and had trouble coming up with the funds to pay it when due. You don’t want to owe the IRS money!
These are tough times with plenty of economic pain to go around. Before you decide to take money out of your retirement account, look in to all of the COVID-19 assistance available. Not only can many types of payments be deferred (mortgages, loans, utilities), there are programs to provide food and other resources. Because this pandemic is affecting so many Americans, lots of assistance is available. When you want to retire but don’t have any money, there won’t be a program for that—you’ll be on your own!!
Would you sleep better at night if you had a trusted professional advising you on financial decisions? Give me a call (336-701-2612) or send me a message.
Investment advisor representative of and investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Fair Winds Financial Advice may offer investment advisory services in the States of North Carolina and Texas and in other jurisdictions where exempted.