So you’ve dipped into savings…What to do next with your retirement account
Cash Flow and Retirement
Tapping an IRA, 401(k) plan, or other tax-deferred accounts to pay current expenses can derail your retirement savings plan. Therefore, it should be viewed as a last resort. Unfortunately, many people reached that point in 2020 or earlier this year due to COVID-19’s financial impact. If you withdrew or plan to withdraw tax-deferred savings as a result of financial hardship, you may need a strategy for getting your retirement plan back on track.
To ease some of the pain, last year’s CARES Act eliminated early withdrawal penalties for people affected by COVID-19 who withdrew up to $100,000 in retirement savings in 2020. The act also provided that account owners can avoid income taxes on the amount withdrawn by returning it to the account within three years.
Retirement plan owners unable or unwilling to return the funds have the option of reporting the distribution and paying applicable taxes, notably over three years. And the Consolidated Appropriations Act, signed into law at the end of 2020, extended similar relief to certain non-COVID-19-related disasters, applicable to eligible distributions made on or after the date of the qualified disaster and before June 25, 2021.
To get an idea of how early withdrawals can affect your retirement plan, consider this hypothetical example. At the beginning of 2020, Pete is 35 years old and has a $200,000 balance in his employer’s 401(k) plan. He contributes $1,000 per month to the plan and expects to retire in 30 years. If his account earned an average return of 7% per year, his balance would be approximately $2.7 million at retirement.
In April 2020, Pete’s wife, Alicia, is laid off as a result of the pandemic. In July 2020, Pete takes a $75,000 distribution from his 401(k) plan to help cover the family’s expenses while Alicia looks for work. He also stops contributing to his plan until July 2021. How does a $75,000 distribution and a year-long suspension of contributions affect Pete’s anticipated retirement balance? The combined action reduces it to $2.1 million — $600,000 less than his original projected balance.
Make up the loss
As you can see, taking an early distribution (even if it’s penalty-free) from a tax-deferred account and suspending contributions can really set you back. So, what can you do to make up for the loss in expected retirement benefits? Ideally, you would return the distribution to the account within three years to avoid taxes, plus contribute some extra to make up for any contributions and earnings you missed during the period of financial hardship. If that’s not possible, think about increasing your monthly contributions by an amount that will enable you to achieve your original savings goal.
In Pete’s case, for example, if he’s unable to return the $75,000 distribution, he might still significantly reduce the tax by increasing monthly contributions from $1,000 to approximately $1,600 when they resume in July 2021. Increasing contributions also allow him to return $38,400 of the distribution within three years and avoid taxes on that amount. The remaining $36,600 could be included in taxable income at a rate of $12,200 per year. Pete won’t quite be back on track with his original goals, but if he keeps up the increased contributions, he can get there.
If financial hardship forced you to take an early retirement plan distribution, you’re not necessarily doomed to a financially insecure retirement. Consider contributing some or all of the distributed funds within three years or increasing your contributions to make up for the lost time. Be sure to amend your tax return if you report distributions as taxable income and later return them to the account within the three-year period. The IRS will refund you. Contact us for advice on saving for retirement and minimizing taxes for your unique situation.