Life Happens

Art by Simone Virgini

Any retirement plan adviser will insist it is a cardinal sin for participants to dip into their defined contribution (DC) plan account before they reach retirement age. But sometimes life’s unexpected events put people in a position where they need money now and their retirement savings is the only available resource to mine.

When the COVID-19 pandemic proved to be such an unexpected event, Congress, in March 2020, passed the Coronavirus Aid, Relief and Economic Security (CARES) Act. The act provided for expanded distribution options and favorable tax treatment for up to $100,000 of COVID-related distributions from DC plans, such as 401(k)s and 403(b)s, and individual retirement accounts (IRAs), if an employer chose to adopt this expanded distribution.

The CARES Act also increased the limit on how much qualified individuals could borrow from their retirement plan and allowed the sponsor to give them up to an additional year to repay the loans. Those who took a distribution under the CARES Act have been given three years to pay the federal taxes, as well as to repay the distribution amount.

“If somebody took $100,000 out and got through the brunt of the pandemic using only $20,000, they’d have three years to pay the $80,000 back and would not have to pay tax on that,” says Matt Cellini, partner and practice lead at Greenspring Institutional Client Group in Towson, Maryland. “Certainly that could make sense, and we saw a number of our clients adopt those provisions of the CARES Act.”

Even so, Cellini says, Greenspring typically advises its clients to limit opportunities for “plan leakage,” which he defines as money withdrawn from an account in a way that will cause permanent capital loss to the account holder. Cellini says most of Greenspring’s clients, on the firm’s advice, chose not to adopt the CARES Act’s distribution provisions but only the loan part, to better preserve their employees’ savings.

While the window the CARES Act created closed at the end of 2020, participants may still encounter any of a variety of financial needs for which they may turn to their plan to fill. And whatever caused the need, raiding one’s retirement savings can hurt.

“If they don’t repay the money, it has an incredibly large, long-term impact on their ability to retire,” Cellini says. He adds that it always makes more sense to take a plan loan rather than a distribution. Once a participant takes a distribution, “he has essentially experienced permanent capital loss because he’s had to pay the tax bill on it, and there’s no ability for that money to continue to grow, tax deferred.”

People should determine to take funds from their retirement plan only “when they’re truly in the retirement phase,” he says, and even then based on need. He encourages employees to grow an emergency fund so they have a buffer in place and can keep their retirement account intact, he says.

Ellen Lander, principal and founder of Renaissance Benefit Advisors Group LLC, in New York City, stresses that borrowing of any kind should be avoided whenever possible. Yet, “things can happen, and there may be times when [people] have to borrow,” she says, noting that employees should be reassured that this is no reason not to join a DC plan.

From Lander’s experience, most people consider the funds in their retirement plan as illiquid and untouchable—at least not without a severe penalty. Nevertheless, she says, participants can leverage their account when they have to borrow because they can do so from their plan at a more favorable interest rate than from a bank or by credit card.

She also points out that if a DC plan matches employee contributions, this yields an added advantage. “I can borrow from my plan [in emergencies], and I’ve saved money, and I also got the matching contributions,” which continue to earn, Lander says. “But if I’m concerned about future debt and choose not to be in a defined contribution plan, then I get nothing from my employer.”

Lander says she is a big believer in “merchandizing the DC plan,” which she explains as getting people to make savvy decisions and understand that the plan can be a financial tool, particularly when it comes to loans. For example, she says, if someone’s roof caves in and causes a sudden and unexpected expense, and there is too little insurance and no emergency fund, then that person will have to borrow the money from somewhere.

“I can borrow it from the bank, maybe, or I can put it on my credit card,” she says, though she cites the time and effort involved in applying for a bank loan, with no guarantee that the loan will be approved, or high interest rates if it is. “Credit cards are even worse: If I pay for that roof on my credit card, what am I paying—21% interest?”

Because most retirement plans have an interest rate of either the prime rate or the prime rate plus 1%, “you’re able to borrow the way a corporation can borrow—not at 21% interest,” Lander observes.

John Bartlett, director of retirement services at CFS Investment Advisory Services, in North Arlington, New Jersey, likens credit card interest rates to those provided by loan sharks. He also recommends borrowing from the employer DC plan, vs. taking a hardship distribution, in cases of unexpected financial need. “If you take a hardship distribution, you’re looking at almost 40% in taxes, plus the penalty to have access to that money. That can be detrimental to any retirement planning,” Bartlett says.

Not only do participants receive a more favorable interest rate, but they also get to pay themselves back and, with standard plan loans, can do this over a five-year period, he says.