Penalty-free 401(k) Withdrawal Due to a Disaster? Here's What You Need to Know

Given the financial hardship many Americans faced as a result of the COVID-19 pandemic, the CARES Act provided many avenues of financial relief for individuals and businesses across the country. In particular, the ability to withdraw retirement funds without penalty if you'd been affected by the pandemic. Provisions of this law expired at the end of the year, but more help became available with the passage of additional legislation.

December 30th, 2020, was the last day to take a coronavirus-related distribution, and Congress didn't extend this into 2021. But in late December, President Trump signed the Consolidated Appropriations Act, 2021 to provide disaster-related tax relief. As part of the law, there's a provision that allows impacted individuals to take a qualified disaster distribution from their retirement accounts. Similar to the withdrawal exemption in the CARES Act, eligible individuals can take up to $100,000  from their retirement accounts, without being subject to the 10 percent penalty that typically applies to early withdrawals. Those who choose to take a distribution  can pay the federal taxes over a 3 year period, and have up to three years to repay the distribution amount, starting on the day they take the distribution.

Depending on your situation, taking a 401(k) early withdrawal from your retirement account may be a viable option, but it's not a decision to make lightly. There are some important things to know first.

Who is qualified for a 401(k) qualified disaster distribution?

Disaster relief is available to individuals who reside in FEMA declared disaster areas (for reasons other than COVID-19), such as areas impacted by hurricanes and wildfires that occurred after December 31st, 2019 through 60 days after the enactment of the law (February 25th, 2021). An individual must have also suffered an economic loss due to the qualified disaster.

The Consolidated Appropriations Act also has provisions for disaster related hardship withdrawals:

Hardship Distributions (Purchase Primary Residence):

• Hardship distribution taken to purchase or construct a principal residence in the disaster area.
• Hardship distribution was taken within the 180 days before the disaster event date and 30 days after the disaster event date.
• May be repaid to the retirement plan between the first day of the disaster event date and no later than 180 days after enactment of this bill (June 20, 2021).

Loans (due to Federal Disaster Event - NON-COVID):

• Loan requested by participant whose principal residence is in the disaster area.
• Participant must have sustained an economic loss due to the disaster event.

New Disaster Loans:

• Retirement plan loans taken between December 22, 2020 and within 180 days following the enactment of this bill (June 20, 2021).
• Maximum Loan Amount = the lesser of $100,000 OR 100% of the participant’s vested account balance.

New & Outstanding Disaster Loans:

• Loan payment dates that are due between the disaster event date and ending 180 days after the disaster period may be delayed.
• Loan repayments may be delayed for one year (or, if later, 180 days after the legislation’s enactment; June 20, 2021), with the loan’s term extended by the period of the delay.
• Loan balances will continue to accrue interest during this delayed timeframe.
• The max 5-year loan term is disregarded for outstanding loans deferring payment for 1 year.

Employers have options under latest law

Although the Consolidated Appropriations Act temporarily relaxes rules for eligible individuals to access their retirement funds, businesses don't necessarily have to include these provisions in their plan provisions. Businesses that had to layoff workers due to business slowdowns also have more time to restore their workforce to at least 80 percent to avoid partial plan termination rules relating to their retirement plan. The partial retirement plan termination rule would be relaxed during a plan year that includes the period between March 13, 2020, and March 31, 2021, deferring assessments until March 2021.

Should you take a distribution from your 401(k) or IRA?

Like the CARES Act, the Consolidated Appropriations Act allows you to withdraw funds from both a 401(k) and an IRA, as long as the amount is up to $100,000 across all accounts. If you are deciding whether to take a distribution from either your IRA or a 401(k), think about factors such as each of the account's typical rules around penalties and taxes. F

How taking a 401(k) distribution affects your retirement

Time in the market and compounding interest are critical factors when it comes to your retirement savings. While investment returns will vary, in general more money in the market means more at retirement, while anything you withdraw now is that much less you'll have for your golden years. Plus, taking money out means missing any potential gains your investments would have seen along the way, even if you reinvest the money down the road.

That's why it's important to carefully assess your situation; if you're experiencing a true emergency and your retirement is your only financial source, consider limiting the amount you take out to only what you need. If you're certain that you can pay yourself back, there's also less of a risk in going this route. But if you can go without touching your nest egg, over time you may be able to reap the rewards of compound interest and avoid any potential losses.

Taxes to consider

Qualified disaster contributions require you to claim the amount withdrawn from your retirement account as income on your tax returns, which you can pay all at once or over the span of three years (e.g., a $3,000 distribution in 2021 means you would report $1,000 in income on your federal income taxes for 2021, 2022, and 2023). This may help prevent you from being in a higher tax bracket than you are usually in a single year, depending on the amount of your distribution. Additionally, if you pay the distribution back within three years, you can file for a refund for the taxes you paid on that distribution.

If your employment has been impacted or you otherwise expect your income to be lower in 2021 than 2022 and 2023 (when the economy and businesses may be more fully recovered), consider claiming the entire amount of the distribution on your 2021 tax return. This could minimize how much you're taxed on this income, and you'll have two years to pay back the distribution and eventually get a refund.

401(k) loan or 401(k) withdrawal?

While similar, a 401(k) loan and 401(k) withdrawal aren't interchangeable and have a few key differences. While you can use either to access up to $100,000 of your retirement funds penalty- and tax-free as part of the Consolidated Appropriations Act, they each have their own rules.

As part of a 401(k) withdrawal:

• Repayment isn't required.
• There's no withdrawal penalty.
• Distribution will be taxed as income, but you can pay it back within three years and claim a refund.

As part of a 401(k) loan:

• You must repay the loan within a specified time frame (typically five years).
• The loan amount isn't taxed initially, and there's no penalty. If you can't pay it back within the specified time frame, the outstanding balance is taxed and you'll also be assessed a 10 percent early withdrawal penalty, if you are under age 59 1/2.
• If you leave your job, you have until mid-October of the following year to offset the outstanding loan amount.   Otherwise, you could owe 401(k) early withdrawal taxes and penalties.

Work with your plan sponsor to learn more about the pros and cons of a 401(k) withdrawal vs. 401(k) loan.

When to consider a retirement early withdrawal

You should consider making withdrawals from a retirement account only under dire circumstances. Given the financial and emotional impact that situations such as the COVID-19 pandemic as well as national disasters have had on Americans, there are situations when it could make sense to withdraw early.

A means of avoiding high-interest debt

You may consider finding quick financial relief by putting expenses on a credit card or taking out a loan. Know that both of these options require you to pay back the amount with interest, which could make the amount you owe much greater than you originally needed (depending on your credit, interest rates, and payback terms). Alternatively, withdrawing from retirement accounts in a disaster situation gives you a cushion of three years to pay the amount back, interest-free.

To keep your living arrangements intact

Being at risk of eviction or foreclosure is a serious emergency for you and your family, in which case using retirement funds can be a viable option. If your landlord or mortgage lender hasn't provided any options or assistance during this difficult time, you may consider paying your rent or mortgage with this money.

To meet additional essential needs

Money for items such as medical expenses, prescriptions, food, or elder care add up fast. If you do decide pulling money from 401(k) or other retirement funds makes sense in a disaster scenario, consider taking out only what you need and set up a plan to pay back the amount no later than the three-year time frame.

Consider all of your financial options

When you need cash in a crunch, ideally you have options: using money saved, dipping into emergency savings, getting a loan, or possibly — as a last resort — withdrawing money saved for retirement. Consider the relief available if you've been impacted by a FEMA declared disaster , and talk to your plan sponsor and/or retirement services provider before taking any next steps.