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Cashing Out a 401k? Why It May Not Be The Best Emergency Fund Option

As we’ve discussed previously, there are several ways to build an emergency fund to help see you through a seismic life event or an urgent financial situation, but is cashing out a 401k one of the best options for an emergency fund?

Cashing out a 401k

The Financial Impact of Cashing Out a 401k

Cashing out a 401k may result in several consequences, some immediate and others that you likely will not feel for many years. Typically, in pre-COVID times, withdrawing from a 401(k) before the age of 59½ came standard with the following:

  • A 10% early withdrawal tax penalty.
  • Mandatory federal tax withholding of at least 20%.
  • The withdrawn amount being taxed as ordinary income, which may cause more taxes being owed, depending on your total yearly earnings, deductions, tax bracket, and other factors.

The CARES Act, however, changed all this.

Under the CARES Act, those impacted by the pandemic are permitted to access up to $100,000 from their 401k and other retirement plans with fewer consequences.

Before we consider whether cashing out a 401k is a viable emergency fund option, let’s dig deeper into what the IRS is now allowing regarding access to your 401k under the CARES Act:

  • The CARES Act provides for expanded distribution options and favorable tax treatment for up to $100,000 of coronavirus-related distributions from eligible retirement plans (such as 401k and 403b plans, and IRAs) to qualified individuals.
  • The 10% early withdrawal tax penalty does not apply to coronavirus-related distributions made in 2020.
  • There are no longer mandatory federal tax withholding requirements.
  • Cashing out a 401k in 2020 for coronavirus-related reasons will allow the tax burden to be spread out over a three-year period, starting with the year in which you receive the distribution. The IRS provides this example: if you receive a $9,000 coronavirus-related distribution in 2020, you would report $3,000 in income on your federal income tax return for each of 2020, 2021, and 2022, while going on to note that you do still have the option of including the entire amount as ordinary income in the first year.
  • Should your finances improve after cashing out a 401k, you may repay all or a part of the amount withdrawn within three years of the date of distribution, and then claim a rebate on any taxes paid on the repaid portion of the 401k cash out.
  • 401k loan rules have changed under the CARES Act too. Previous retirement plan loan rules limited borrowers to accessing 50% of their vested balance as a loan but now plan participants can borrow 100% of their vested balance up to $100,000, and payments on 401k loans can be deferred for up to a year.

Is Cashing Out a 401k One of the Best Emergency Fund Options?

Should you have been impacted by the coronavirus pandemic, the CARES Act does make it easier and less painful to withdraw from or borrow against your 401k retirement plan. In those specific cases, cashing out a 401k may be a viable emergency fund option, however if you do not choose to repay the amount withdrawn under those new guidelines, you will still be in a position of having less funds available for your future and a potentially significant tax bill due next April.

Whereas both using the equity in your home through a HELOC or slowly building up a savings account to serve as your emergency fund each come with less immediate and long-term economic impact, cashing out a 401k creates an immediate taxable event (and if under 59 ½ years of age, may also come with that 10% early withdrawal tax penalty). Cashing out a 401k may also significantly reduce the amount you will have for your retirement and that may potentially elongate your working years. This is because, while your investments may still be growing and compounding, you will have sold all or a portion of those investments in the cash out, thus creating less potential for growth over time.

The Biggest Cost of Cashing Out a 401k

Most financial advisors would agree that cashing out a 401k should be the last resort option for an emergency fund, even if the ordinary taxes due are spread out over three years and the early withdrawal penalty is waived. This is because the biggest cost of cashing out a 401k is, potentially, opportunity cost. In selling 401k investments to fund the withdrawal, you could end up missing out on long-term growth should the stock market recover and continue to flourish at its historical average rate (average annualized return of the S&P 500 Index between 1973 to 2016 was nearly 12%).

Of course it’s challenging to consider the far off future if the present day situation is dire, but do think long and hard about cashing out a 401k and the impact it will have on your ability to retire and enjoy your later years, before taking that step to provide yourself and your family with an emergency fund.

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