One major effect of the COVID-19 pandemic is its effect on the economy and the cash flow issues it is creating for small business owners of all types – including architectural firms. Should you consider borrowing from your 401(k) now?
As an architect, if you have a 401(k) plan at work and need some cash, you might be tempted to borrow or withdraw money from it. But keep in mind that the purpose of a 401(k) is to save for retirement. Take money out of your 401(k) now, and you’ll risk running out of money during retirement. Importantly, you may also face stiff tax consequences and penalties for withdrawing money before age 59½. Still, if you or your staff are facing a financial emergency-and your 401(k) is your only source of available funds — borrowing or withdrawing money from your 401(k) may be your only option.
Your plan may allow for loans from participant accounts. This may be a better option than withdrawing money.
Generally, obtaining a 401(k) loan is easy–there’s little paperwork, and there’s no credit check.
The good news is that if you do need to make a withdrawal, the CARES Act temporarily loosens the rules on hardship distributions. Thus, if you are affected by the crisis, you may not face the usual 10% penalty for withdrawing up to $100,000 before age 59½.
The law also doubles the amount 401(k) participants can take in loans from an account for the next six months to the lower of $100,000 or 100% of the account balance. IRAs don’t permit loans.
There are several other temporary changes to retirement plan rules that come into effect with the Relief Package legislation.
How much can you borrow?
No matter how much you have in your 401(k) plan, you probably won’t be able to borrow the entire sum. Generally, you can’t borrow more than $50,000 or one-half of your vested plan benefits, whichever is less. (An exception applies if your account value is less than $20,000; in this case, you may be able to borrow up to $10,000, even if this is your entire balance.) The Relief Package has increased the maximum to $100,000 and increased the time allowed to pay back the loan.
What are the requirements for repaying the loan?
Typically, you must repay money you’ve borrowed from your 401(k) within five years by making regular payments of principal and interest at least quarterly, often through payroll deduction. However, if you use the funds to purchase a primary residence, you may have a much longer period of time to repay the loan.
Make sure you follow to the letter the repayment requirements for your loan. If you don’t repay the loan as required, the money you borrowed will be considered a taxable distribution. If you’re under the age of 59½, you’ll owe a 10 percent federal penalty tax, as well as regular income tax on the outstanding loan balance (other than the portion that represents any after-tax or Roth contributions you’ve made to the plan).
What are the advantages of borrowing money from your 401(k)?
- You won’t pay taxes and penalties on the amount you borrow, as long as the loan is repaid on time.
- Interest rates on 401(k) plan loans must be consistent with the rates charged by banks and other commercial institutions for similar loans.
- The interest you pay on borrowed funds is generally credited to your own plan account; you pay interest to yourself, not to a bank or other lender.
What are the disadvantages of borrowing money from your 401(k)?
- If you don’t repay your plan loan when required, it will generally be treated as a taxable distribution.
- If you’re an employee of the practice and leave your employer’s service (whether voluntarily or not) and still have an outstanding balance on a plan loan, you’ll usually be required to repay the loan in full within 60 days. Otherwise, the outstanding balance will be treated as a taxable distribution, and you’ll owe a 10 percent penalty tax in addition to regular income taxes if you’re under age 59½.
- Loan interest is generally not tax deductible (unless the loan is secured by your principal residence).
- You’ll lose out on any tax-deferred interest that may have accrued on the borrowed funds had they remained in your 401(k).
- Loan payments are made with after-tax dollars.
Your 401(k) plan may have a provision that allows you to withdraw money from the plan while you’re still employed if you can demonstrate “heavy and immediate” financial need and you have no other resources that you can use to meet that need (e.g., you can’t borrow from a commercial lender or from a retirement account and you have no other available savings). Many plans allow hardship withdrawals only for the following reasons:
- To pay the medical expenses of you, your spouse, your children, your other dependents, or your plan beneficiary
- To pay the burial or funeral expenses of your parent, your spouse, your children, your other dependents, or your plan beneficiary
- To pay a maximum of 12 months’ worth of tuition and related educational expenses for post-secondary education for you, your spouse, your children, your other dependents, or your plan beneficiary
- To pay costs related to the purchase of your principal residence
- To make payments to prevent eviction from or foreclosure on your principal residence
- To pay expenses for the repair of damage to your principal residence after certain casualty losses.
Note: You may also be allowed to withdraw funds to pay income tax and/or penalties on the hardship withdrawal itself, if these are due.
As noted earlier, in addition to the reasons stated above, the Relief Package will allow withdrawal of up to $100,000 without penalty for Coronavirus related need.
How much can you withdraw?
Generally, you can’t withdraw more than the total amount you’ve contributed to the plan, minus the amount of any previous hardship withdrawals you’ve made. In some cases, though, you may be able to withdraw the earnings on contributions you’ve made. Check with your plan administrator for more information on the rules that apply to withdrawals from your 401(k) plan.
What are the advantages of withdrawing money from your 401(k) in cases of hardship?
The option to take a hardship withdrawal can come in very handy if you really need money and you have no other assets to draw on, and your plan does not allow loans (or if you can’t afford to make loan payments).
What are the disadvantages of withdrawing money from your 401(k) in cases of hardship?
- These withdrawals are normally used as a last resort. Taking a hardship withdrawal will reduce the size of your retirement nest egg, and the funds you withdraw will no longer grow tax deferred.
- Hardship withdrawals are generally subject to federal (and possibly state) income tax. A 10 percent federal penalty tax may also apply if you’re under age 59½. As mentioned above, the penalty tax may be lifted for Coronavirus-related withdrawal. (If you make a hardship withdrawal of your Roth 401(k) contributions, only the portion of the withdrawal representing earnings will be subject to tax and penalties.)
- You may not be able to contribute to your 401(k) plan for six months following a hardship distribution.
Minimum Distribution waiver related to the Relief Package
The Relief Package will allow for a waiver of minimum distribution for 2020. This will allow individuals taking minimum distributions to waive liquidating assets at low share value caused by the virus-related stock market losses.
Before Taking any Action
With the Relief package signed, it will now take some time to understand all the impacts to retirement plan rules, as well as time for plan administrators to make the necessary changes to accommodate the changes. Please work with your plan administrator, accountant and lawyer before taking any action.
For more information:
The AIA Trust is here to help
The AIA Trust offers retirement savings plans and distribution options through Equitable to assist you in achieving your retirement goals. Plans can be established for one-person firms (or components)—or for many employees—utilizing a variety of retirement savings and distribution vehicles. Equitable Life can assist you toward achieving your goals based on 51* years of experience working with association members and over 25 years with AIA architects. Equitable can help you review your options and offer you choices that can alleviate the burden of establishing and managing a retirement savings plan. It’s one of the ways that the AIA Trust makes it easier for you to focus on doing what you do best: architecture.
Please call 800-523-1125 to speak with a Retirement Program Specialist or visit www.TheAIATrust.com/retirement-plans/ to learn how you can start saving.
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