Whether you've faced illness, job loss or other hardship due to the COVID-19 pandemic, you might consider tapping into your retirement plan early to get some needed funds. While doing so usually means paying an extra tax penalty alongside any taxes due on the withdrawn money, the Coronavirus Aid, Relief and Economic Security Act passed in March 2020 has introduced some leniency for early withdrawals when they're related to hardships from the coronavirus. Read on to learn what you should know about the financial consequences of taking early retirement plan withdrawals and implications on your taxes.
Retirement Plan Tax Basics
When it comes to retirement plans, some of the most common ones you'll find are 401(k), Roth IRA and traditional IRA accounts. All of these account types allow both you and your employer to contribute funds up to set annual limits. Further, they're intended for you to keep your cash in the account until you reach the age of 59 1/2 or otherwise pay a tax penalty except in some specific situations. You'll usually need to make some required minimum withdrawals once you've reached 70 1/2 or else face tax penalties.
However, it's important to know how these accounts differ in terms of the tax treatment of contributed and withdrawn funds:
- With a traditional IRA, you exclude your contributions from your taxable income now and instead pay income taxes on that money upon withdrawal. This works the same for many traditional 401(k) plans.
- Roth IRA plans and Roth 401(k) plans involve paying taxes now on contributed funds so that you don't need to pay them when you withdraw the funds later. These Roth accounts will lead to income taxes, though, if you withdraw earnings on contributions early or if you make any withdrawal before the account has reached five years old.
Read More: Why Is it Important to Invest Money for Retirement?
Typical Early Retirement Withdrawal Rules
Under IRS rules, you'll normally have to face a 10 percent early withdrawal penalty for a traditional IRA or 401(k) withdrawal – on top of the taxes due on the distribution – when you're not at least 59 1/2. Since you pay taxes on your contributed Roth IRA or 401(k) funds in the tax year during which you invest them, qualified early withdrawals from Roth retirement accounts usually don't incur the 10 percent penalty. However, when the money you've withdrawn includes earnings along with contributed funds, then you'll need to pay the penalty alongside income taxes on those earnings.
The good news is that the IRS allows for various exceptions – even when there's no pandemic – so that you can avoid the penalty if you face a qualified hardship or perform specific actions, and these can vary by type of plan. For example, death, total disability, significant medical expenses and plan rollovers lead to no penalty for both 401(k) and IRA owners. IRA owners can additionally get exceptions for educational expenses, first-time home purchases and health insurance premium reimbursement if unemployed. In any case, expect to show an immediate financial hardship to qualify.
Keep in mind that while you can usually make early IRA withdrawals without issue, that might not be the case when you have a 401(k). You'll need to check with your employer and plan administrator to find out if they allow withdrawals early at all or whether they just offer them for certain hardships. Your employer might offer 401(k) loans as an alternative, but that's money you'd need to pay back after a set period of time.
The Coronavirus and Early Withdrawals
As part of the benefits the CARES Act has provided during the pandemic, you'll find that you can avoid the 10 percent penalty on traditional IRA and 401(k) withdrawals through some COVID-19 exemptions. The eligibility includes you or an immediate family member having a positive COVID test as well as a provision for those who have faced adverse financial consequences through events like having to quarantine, losing your job, lack of childcare, not having childcare due to school closures and similar causes. IRS Notice 2020-50 offers a full rundown of COVID-19 hardships that qualify.
If you qualify under one of these guidelines, then you could take out as much as $100,000 from your retirement plans early without the penalty. This is a total limit, so you could pull those funds from multiple retirement accounts if needed. You'll just need to make sure you take the money out in 2020 between Jan. 1 and Dec. 30 as early withdrawals outside these dates won't qualify under the CARES Act provisions.
What to Expect With Taxes
Unless you've only withdrawn contributed funds from a Roth account, the money taken out of your retirement account early usually qualifies as income subject to income taxes. This means that you'll report this amount alongside regular employment and self-employment income on your taxes to calculate your taxable income and taxes due for the year. Due to this, those extra funds might send you into another tax bracket and owe additional taxes.
The good news is that the CARES Act allows for more lenience when it comes to paying back the withdrawn money and avoiding taxes on COVID-related early retirement plan distributions. Rather than report the distributions in full on the tax return you file in 2021, you can spread them across three years to make the tax burden easier to handle. This provision means that 401(k) owners won't need to automatically have 20 percent of their withdrawal withheld for taxes like usual. Further, you can recontribute retirement plan funds over those three years to avoid taxes on them altogether.
Keep in mind that if your retirement plan withdrawal wasn't due to the coronavirus or another qualified hardship under IRS rules, you'll end up paying the 10 percent penalty and extra income taxes when you report the distributions on your next return. You can use this calculator to determine how an early withdrawal can impact you financially in this situation.
Taking Early Retirement Plan Withdrawals
Before proceeding with a coronavirus-related distribution from your retirement plan, closely consider whether you have any other options for getting the money needed during your hardship. After all, the money may help now with important expenses, but it also will no longer sit growing in your retirement plan for you later. If you do decide that withdrawing funds early is best for you, you might decide to recontribute the money over the next few years to avoid the income taxes and continue to work toward saving for retirement.
Once you're ready to start the process of requesting an early retirement plan withdrawal, contact your plan administrator to first ensure that such withdrawals are permitted, especially if you're dealing with a 401(k) account. Know that you may only get access to a certain amount of vested funds in such accounts. It's also worth talking to an accountant or financial advisor to learn if you feel concerned about the future tax implications of the withdrawal to do some tax planning.
You can then expect to either complete a paper withdrawal request form or log in to your retirement plan management website to request the funds. Be prepared to give a reason for the early withdrawal request, specify how you'd like the money (such as a check, electronic funds transfer or rollover) and note whether you'd like taxes withheld now.
- IRS: Publication 590-B (2019), Distributions from Individual Retirement Arrangements (IRAs)
- IRS: Retirement Topics - Exceptions to Tax on Early Distributions
- IRS: Retirement Topics - Hardship Distributions
- Consumer Financial Protection Bureau: Considering an Early Retirement Withdrawal? CARES Act Rules and What You Should Know.
- IRS: Coronavirus-Related Relief for Retirement Plans and IRAs Questions and Answers
- TIAA: The CARES Act Stimulus Package Offers Some Relief From the Economic Effects of Coronavirus
- Forbes: How the CARES Act Eases Retirement Account Rules During COVID-19
- U.S. Securities and Exchange Commission: COVID-19 Related Early Withdrawals from Retirement Accounts—Be Careful of Fraudsters and other Bad Actors Targeting Your Retirement Savings
- IRS: Guidance for Coronavirus-Related Distributions and Loans from Retirement Plans Under the CARES Act
- TIAA: Early Withdrawal Calculator
- SoFi: Understanding the Different Types of Retirement Plans
- Investopedia: Qualified Distribution
- Fidelity: Request a Check
- IRS: 2020 Instructions for Form 8915-E
- IRS. "Roth Comparison Chart." Accessed Nov. 2, 2020.
- IRS. "Early Withdrawals From Retirement Plans." Accessed Nov. 2, 2020.
- IRS. "Retirement Topics-Exceptions to Tax on Early Distributions." Accessed Nov. 2, 2020.
- Chuck Grassley - United States Senator for Iowa. "CARES Act Retirement Provisions FAQ." Accessed Nov. 2, 2020.
- U.S. Department of the Treasury. "The CARES Act Works for All Americans." Accessed Nov. 2, 2020.
- IRS. "Coronavirus-Related Relief for Retirement Plans and IRAs Questions and Answers." Accessed Nov. 2, 2020.
- IRS. "Retirement Topics-Required Minimum Distributions (RMDs)." Accessed Nov. 2, 2020.
Ashley Donohoe has written about business and technology topics since 2010. Having a Master of Business Administration degree, bookkeeping certification and experience running a small business and doing tax returns, she is knowledgeable about the tax issues individuals and businesses face. Other places featuring her business writing include Zacks, JobHero, LoveToKnow, Bizfluent, Chron and Study.com.