About the author: Lamar Watson, CFP®, is a Fee-Only Financial Advisor in the Washington, D.C. area, that works with clients virtually across the country. Lamar's work with his clients focuses on budgeting, employee benefits, paying down debt, buying their first home, and investing. Lamar is the Founder of Dream Financial Planning, a virtual financial planning firm specifically designed to help young professionals and minorities take control of their finances and fulfill their dreams. Feel free to schedule a complimentary consultation to learn how we use the The DREAM Financial Planning Process ™ to help our clients achieve their goals.
On March 27, 2020, President Donald Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (CARES) Act. Amidst the global COVID-19 pandemic, this act is designed to bring economic relief to individuals and businesses who’ve been affected by the resulting economic downturn.
Section 2202 of the act, titled “Special Rules For Use of Retirement Funds,” now allows those affected by COVID-19 to withdraw up to $100,000 penalty-free from their 401(k) or IRA.1
What does it mean to be "impacted by COVID-19?" Congress defines this broadly to include those who:
- Have been diagnosed with COVID-19;
- Have a spouse or dependent who has been diagnosed with COVID-19;
- Experience adverse financial consequences as a result of being quarantined, furloughed, being laid off, or having work hours reduced because of the disease;
- Are unable to work because they lack childcare as a result of the disease;
- Own a business that has closed or operate under reduced hours because of the disease; or
- Meet some other reason that the IRS decides to say it is OK.
This new option to withdraw from your 401(k) or IRA is on the table, but should you consider taking it? Below we’ll discuss what you need to know about this change and what to consider before making a decision.
Penalty-Free Access to Retirement Savings
Traditionally, there has been a 10 percent penalty for withdrawing funds from a 401(k) or IRA account before reaching the age of 59 ½. But through changes passed in the CARES Act, this penalty will be waived for individuals who choose to tap into their retirement savings accounts and withdraw up to $100,000 to cover financial burdens caused by the COVID-19 pandemic.1
If you choose to withdraw, you will have the option to spread the tax liability of this additional income over the next three years, and you will have three years to return savings (up to the full amount withdrawn) back into the account.1
Increase in 401(k) Loan Limits
Aside from withdrawing altogether from your retirement savings account, some plan sponsors offer the option of taking out a loan on your 401(k) or IRA. In the past, there have been limits on how much you can withdraw. According to the IRS, the maximum amount was previously “(1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.”2
In light of recent events, the CARES Act has adjusted this loan limit to a maximum amount of 100 percent of your vested account balance, or $100,000, whichever is less.1 This option will be available for individuals for 180 days after the CARES Act is enacted. Additionally, anyone owing a 401(k) loan repayment before December 31, 2020, can delay their repayment for up to one year.1
While the amount one can withdraw in a loan has doubled, it’s important to remember the IRS has not changed its rules on loan repayment. According to the IRS, “Repayment of the loan must occur within 5 years, and payments must be made in substantially equal payments that include principal and interest and that are paid at least quarterly.”2 That means that if you choose to take this option, you need to be prepared to pay the full amount back in substantial installments each year.
Considerations About Withdrawing From Your Retirement Savings
As is true for any other circumstance, the decision to withdraw from your retirement savings account early should never be taken lightly. Depending on your timeline toward retirement, $100,000 accruing compounding interest over the next couple of years could yield significant growth. In fact, the younger you are, the greater the dent you’re putting on your future retirement funds - if you choose to withdraw from your 401(k) or IRA without paying it back.
As you address the need for money now, remember to consider your need for money in the future. Is creating a significant reduction in your future retirement income the best option for addressing your present financial hardships, or would it be better to pursue alternative options - such as a personal loan, HELOC or tapping into your emergency savings?
A $10,000 withdrawal as 30 year old could cost you over $280,000 by the time you retire.
We always work with our clients to establish a solid foundation of personal finance fundamentals. Saving early and often, even a small amount, is crucial to long term success. When working with clients and taking them through the Dream Financial Planning Process ™, we work to optimize their budget and establish an emergency fund so they can handle unexpected expenses. We never recommend withdrawing money from a 401k unless it's a last resort or to possibly buy a home.
For example, let's say you're a 30-year-old that is contemplating withdrawing $10,000 from your 401k or IRA (Individual Retirement Account). If you don't qualify for an exemption that $10,000 is going to be approximately $7,000 after taxes and penalties depending on your tax rate.
You plan to retire at 65 years old, so you have a 35-year time horizon. $10,000 invested for 35 years, earning 10% per year, which happens to be the long-term return of the stock market as defined by the S&P 500 index, comes out to approximately $281,000.
What's a 401k?
While retirement may seem light-years away, any seasoned financial professional will tell you that planning for your golden years should start as early as possible. While it can be hard to think so far ahead, your company may help you prepare for the future by offering a 401k plan.
A 401k is a retirement savings plan that is often part of many companies' benefits packages. This plan enables you to defer money from your paycheck to be put into a 401k investment account. In addition to your contribution, many companies will also put money into your 401k, "matching" a portion of your allocation.
Usually, there will be a pre-set amount that is deferred from your paycheck, but you can alter how much you want to put into your 401k. You may choose to dial the amount up or down depending on your financial situation and your company's offerings. For example, if your employer matches precisely what you put in and you are financially stable, you usually will want to contribute as much as you can to your 401k.
Understanding your company's 401k plan is the first step to making the most of it.
Discover What Plan(s) Your Company Offers
Traditional Pre-Tax 401k
With a traditional 401k, you save on taxes now in two ways. First, since your reported salary is reduced by the amount put into your account, you'll pay fewer income taxes. Second, the money inside the account grows tax-deferred, so you don't have to pay tax on the gains each year. You'll only pay tax on the amount you withdraw during retirement.
With a Roth 401k, contributions are made with after-tax dollars, and you do not pay on the amount withdrawn during retirement. Unlike the traditional 401k, you'll save on taxes in the future rather than in real-time. With this plan, you do not reduce your earned income by the amount contributed to your account. However, your account will grow tax-free, and you'll withdraw money tax-free during retirement.
For the tax year 2020, the contribution limit will be $19,500 per individual. If you have multiple plans, the combined contributions are capped at $19,500.3
Choosing the Right 401k Plan for Your Situation
If your employer offers both a pre-tax 401k and a Roth 401k, you'll have to decide which plan is right for you. You'll pay taxes on a pre-tax 401k when withdrawing, but you'll pay taxes on Roth 401k contributions now, and this difference will play a role in choosing the best plan for your needs.
Usually, it makes sense to make Roth contributions in the early stages of your career when most people have a lower salary because your tax rate will not be as high. In this way, the impact on your dollars will not be as severe as it would be with a higher tax rate due to a higher salary. On the other hand, you may prefer to make pre-tax contributions during the later stages of your career when your salary is higher because your tax rate will also be greater.
Should You Also Open an IRA?
Aside from your employer's 401k plan, you have the option to open an Individual Retirement Account (IRA). This may be a wise option for those who are in the early stage of their career, but their employer only offers a pre-tax 401k. In this scenario, opening a Roth IRA enables you to make after-tax contributions at a time in your life when you have a lower tax rate.
The annual Roth IRA limit is $6,000 in both 2020 and 2019, up from $5,500 in 2018 (if you're 50 or older, you can add $1,000 to those amounts). The maximum Roth contribution amount applies to all of your traditional and Roth IRAs, combined
If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $137,000 for the tax year 2019 to contribute to a Roth IRA, and if you're married and file jointly, your MAGI must be under $203,000 for the tax year 2019.
Understand Your Investment Options
Many plans will allow you to choose between multiple types of investments, like different mutual funds. You'll want to thoroughly explore these options and consider which one is fitting for your circumstances.
401k Investment Options
Over the past few months, I've helped multiple clients review their employee benefits package. I'm often asked to review their 401k and help them select the best investment options for their 401k plan. The first thing I look for is fees. I want everyone to understand that investing in your 401k isn't free. While 401k plans vary widely from employer to employer, I'll share a few tips to help guide you in making the best choices.
Why I don't like Target Date Funds
The premise behind target-date funds is convenience. You pick the investment option that is closest to the year you wish to retire. The firm that is managing your money will automatically adjust the mix of stocks or equities, which are considered aggressive investments in your account, to more conservative investments as you get closer to retirement. This practice, known as asset allocation refers to the strategy of dividing your investments among different asset categories, such as stocks, bonds, real estate, cash, and cash alternatives.
The asset allocation in the "XYZ 2055 fund" or whatever it's called in your 401k plan is only based on your approximate retirement date. They're not taking into account your personal situation, risk tolerance, or individual retirement goals. That fund also isn't going to help you figure out how much you need to retire or how to use the assets you've accumulated to replace your paycheck during retirement.
Target date funds are generally some of the more expensive options in your 401k plan. You pay a premium for this product and the convenience of them automatically adjusting your asset allocation as you age.
Another problem with Target-date funds is that there is a really good chance you're not going to retire with the company you're working for in your 20s and 30s. The median number of years that wage and salary workers have worked for their current employer is currently 4.6 years, according to an Economic News Release from the Bureau of Labor Statistics. So, the whole premium you're paying the target date fund or mutual fund doesn't even come in to play because you'll likely leave the employer before the allocation is changed in a meaningful way.
What should I do with my 401k?
- Check for fees and select low cost passively managed options. Investment options that fit this criteria might have total market index or S&P 500 in the title and will most likely have the lowest fees.
- Stay away from target-date funds.
- Check your asset allocation.
- Understand and select an option that matches your risk tolerance.
Reasons to Rollover your 401k to an IRA when you change jobs
- Ability to work with a Fee-Only Financial Advisor that can help you figure out how much you'll need to retire and how to use the assets you've accumulated to replace your paycheck during retirement.
- You can manage the account yourself.
- Unlimited investment options
- Lower cost investment options
- Access to funds in case of an emergency. While we never recommend taking money out of retirement accounts, pre-retirement emergencies happen. It's hard to take money out of 401ks until you separate from your employer.
What do I do with my 401k plan when I leave my employer?
- Roll it over into an Individual Retirement Account (IRA) with no tax consequences.
- You can leave your money in the old 401k plan.
- Roll it over into your new company's 401k plan.
- You also can take some or all of the money out, but there are severe tax consequences and typically a 10% penalty you'll have to pay on top of the taxes.
Is Your Employer Contributing to Your 401k?
In many scenarios, your employer will also contribute to your 401k. These contributions are pre-tax, so you'll only pay taxes on the money when it's withdrawn in retirement. There are several types of employer contributions:
With a matching employer contribution, your employer contributes the same amount as you. In some circumstances, there is a minimum amount at which your employer will contribute. If this is the case, some may decide to contribute at least the minimum. If your employer provides a matching contribution, you should always contribute enough to get the full match; it's free money.
A non-elective employer contribution means that your employer will put in the same percentage for every employee, even if the employee is not contributing.
In a profit-sharing 401k, employers will delegate a percentage or dollar amount of the company's profit to employees' 401k accounts.
Find Out When Your Employer Contribution Dollars Are Yours
Frequently, an employee can only keep its employer's contributions after a certain number of years in the company, otherwise known as "vesting." When you're vested after a certain number of years, you now own the contributions made by your employer.
If you want to make the most of your employer's plan, you'll want to find out when you are vested. You may decide to part ways with your job only after you are vested, allowing you to take full advantage of your company's 401k plan.
Once you understand the specifics of your company's 401k offerings, you'll be able to decide how to make the best of the plan for your needs and goals.
Dream Financial Planning Process ™
Whether you're managing student loan debt, starting a business, or considering buying your first home, the DREAM Financial Planning Process™ is tailored to the unique needs of busy professionals is their 30s and 40s. This process focuses more on short-term goals while you grow and evolve in your personal and professional life. If you're looking for guidance on: Financial Planning, optimizing employee benefits, budgeting, student loans, and managing your 401k or investments we can help.
With uncertainty surrounding the economic stability of our country, it's okay to have fears and anxieties surrounding your own savings and investments. The most productive course of action from here is to reach out to Dream Financial Planning (or whoever your trusted advisor might be) and discuss your options. It's easy to have knee-jerk reactions when it feels like the bottom is falling out, but it is imperative to make decisions using research-backed data and a level head. If you'd like a Complimentary Review and risk assessment of your investment portfolio feel free to send me an e-mail.
On the first Thursday of every month I send out a monthly newsletter with tips and tricks to help you manage your Finances. In the April Newsletter I discuss the recent economic stimulus package and what it means for you. I also include two downloadable PDFs with quick tips to help you navigate these trying times.
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