Wharton’s Olivia S. Mitchell talks with Wharton Business Daily on Sirius XM about the downsides of 401(k) loans.

Millions of Americans find themselves strapped for cash with reduced work or lost jobs as the coronavirus pandemic roils the economy with no end in sight. The Coronavirus Aid, Relief and Economic Security (CARES) Act passed in late March offers some respite with the promise of direct checks of $1,200 for individuals ($2,400 for couples) with an additional $500 for each child, and expanded unemployment insurance benefits. It also opens up a bigger cash window by waiving the 10% penalty on withdrawals of up to $100,000 from 401(k) accounts by those below 59.5 years of age. Earlier rules required those aged less than 59.5 years to pay a penalty on withdrawals.

Attractive as it might seem, tapping retirement savings is fraught with risks that need careful consideration, according to experts at Wharton. Those premature withdrawals will not just erode individuals’ retirement nest eggs: Those who lose their jobs after they withdraw from those retirement funds will have to either repay that amount within three years or pay additional taxes. Meanwhile, despair on the job front is growing, with jobless claims nearing 17 million for the last three weeks, and the unemployment rate projected to rise from the current 4.4% to more than 10% by the second quarter.

“Withdrawing assets from retirement plans should be a last resort, done only after using up the household’s emergency funds, taking a bank loan, or borrowing from family if possible,” said Wharton professor of business economics and public policy Olivia S. Mitchell in an interview with the Wharton Business Daily radio show on SiriusXM. “It has tax consequences, and it may lead to a much poorer retirement.” Mitchell is executive director of the Pension Research Council at Wharton.

Wharton professor of business economics and public policy Kent Smetters also advised a cautious approach and suggested that people consider all possible scenarios before deciding to tap their retirement nest egg. “I would advise taking a 401(k) loan only as a very last resort, if other savings have been exhausted,” he said. “Going forward, budget expenses carefully to quickly pay [a loan] back. But, be careful. If you eventually lose your job for good, then you face a tough choice: You must pay back the loan over three years despite having little ongoing income, or you must declare a distribution, which would trigger taxes over three years.” Smetters is director of the Penn Wharton Budget Model (PWBM).

The CARES Act allocates $20 billion for individual tax benefits, which include a suspension of the required minimum distribution for retirement accounts, suspension of penalties for COVID-19 related early withdrawals and charitable deductions. Higher-income households would benefit the most from those provisions related to individual taxes, according to a PWBM analysis of the short-run economic effects of the provisions. Therefore, those provisions would have a lesser multiplier effect on GDP growth than those that benefit lower-income households. According to PWBM projections, those moves will generate an additional $3 billion in GDP over the next two years, out of the total GDP increase of $812 billion the CARES Act could potentially generate.

“Withdrawing assets from retirement plans should be a last resort, done only after using up the household’s emergency funds, taking a bank loan, or borrowing from family if possible.” –Olivia S. Mitchell

But at a micro, individual level, apart from retirement savings, what other doors are open for those looking to raise cash in these times? “Maybe if you’ve been wise, you’ve put together some emergency savings,” Mitchell said. “This is the time to tap that. Maybe you could apply for a personal loan. Maybe you could borrow from relatives. Everybody is in this together now, and avoiding taking a withdrawal from retirement savings is a better option, unless you really have no other choice.”

The Hard Facts of 401(k) Withdrawals

People have two avenues by which they can take money out of their 401(k) under the new CARES Act. One is a penalty-free withdrawal from it and the other would be to take a loan from their plan. They are only allowed to borrow what are called “vested withdrawals,” that is, the amount of money that they have put in. Any matching contributions from their employers are available only after they meet the employer’s vesting rule, which is usually a year.

The act allows people to withdraw money from their retirement accounts as loans without the usual 10% penalty for early withdrawal if they are younger than 59.5 years. It also suspends the 20% income tax that, under earlier rules, was subtracted from the amount withdrawn from retirement accounts. “That was essentially a pre-payment for the income taxes that the withdrawals would attract,” said Mitchell. The income tax due on these distributions can now be spread out over three years. “Whether or not that’s a good idea depends on your likely tax bracket this year, next year, and the year after – which is, of course, hard to judge at this point,” she added.

“You really should think twice, if not three times, before taking the money out,” Mitchell continued. “If you have borrowed from the plan, then you have to pay it back over a period of time, plus interest…. [That] gets to be a difficult quandary for people who have lost their jobs.”

However, some employers won’t allow access to these funds, Mitchell pointed out. “It is up to the employer whether he or she wants to allow you to take a loan,” she said. “Some plans do not permit it, and therefore you will not be able to access it unless the plans are amended…. It’s fair to say that plan sponsors are in a bit of a quandary because on the one hand, they understand their employees and former employees are hurting financially, and they want to give them access to the assets. On the other hand, they understand that these are supposed to be retirement funds, and people should do whatever they can to avoid taking it.”

It is possible for a plan sponsor, or an employer, to change the rules on 401(k) loans and withdrawals, Mitchell continued. “But it usually takes a 30-day announcement ahead of time, and it might even take 90 days, if you’re talking about suspending the match,” she said. “You can’t just change the rules willy-nilly.”

Like employees, plan sponsors are also worried about their cash flow problems. “Employers are trying to keep paying employees and meeting the bills, but they don’t have sufficient cash,” said Mitchell. “So, [some are] really concerned and [are] hoping to suspend the match – that is, to stop matching dollar for dollar, or 50 cents a dollar on whatever the employees are contributing.” She noted that employers need to give advance notice of 90 days before suspending or reducing their matching contributions.

“It has been estimated that close to 200,000 companies are going to now start suspending or cutting back on their matches,” Mitchell noted. The Wall Street Journal reported an estimate by the American Retirement Association that in the wake of the pandemic, more than 200,000 retirement plans sponsored by small companies are at risk of being permanently terminated.

“I would advise taking a 401(k) loan only as a very last resort, if other savings have been exhausted.” –Kent Smetters

Impact Down the Road

Those who decide that their best option is to tap their retirement savings have to overcome some thresholds before they get that money in their bank. “Technically, to be able to take a hardship withdrawal, you do have to meet certain criteria – that is, it has to be initiated by something associated with the coronavirus,” Mitchell said. Those criteria would typically be scenarios where a person or his/her spouse has tested positive for COVID-19, or they have been laid off from their job or furloughed because of the pandemic. Or, for example, their childcare support has been cancelled and therefore they can’t go to work.

“In practice, most plan sponsors are allowing a pretty liberal interpretation of [the criteria],” Mitchell noted. “The effort is to give people quick access to cash.”

However, withdrawals from retirement accounts may not turn out to be an attractive opportunity for many, Mitchell pointed out, citing recent research by Fidelity Investments. The average 401(k) balance for people in their twenties was about $11,800, and $42,400 for those in their thirties, the study showed. The average balances rose to about $174,000 for people in the 50-59 years age bracket. (The study was conducted in December 2019, before the coronavirus outbreak assumed pandemic proportions.)

“Even though the CARES Act says you can access up to $100,000, very few people are actually going to have that much to access,” Mitchell said. “Not only is the money not there … but it will definitely have a negative effect on retirement downstream.”

The CARES Act also doesn’t force people to take required minimum distributions out this year. Earlier rules required individuals who attain the age of 70.5 years to withdraw about 4% from their retirement accounts. But it also may not be the best time to make those withdrawals, Mitchell suggested. The required minimum distributions were calculated using last year’s stock market values, which were higher than they are now. “So 4% out of a depleted pool is something that, if you can defer, you probably should,” she said. As of now, only about 20% of retirees withdraw the minimum required amounts from their retirement accounts, while the rest take out more, she noted. Those that defer their withdrawals by a year could “hope that the money that is invested recoups its value, and then take it next year,” she added.

Options Beyond CARES

With all its helpful features, the CARES Act “is really not a stimulus act,” Mitchell noted. “It’s an effort to be a lifeboat. It’s a fairly short-term solution.” Even the direct transfer of $1,200 for a single filer with income under $75,000 is a one-time check, and that it is “not going to really save the day, unfortunately,” she noted. “We’re going to need much more stimulus and much higher unemployment benefits, even more than have been already implemented.”

“We’re going to need much more stimulus and much higher unemployment benefits, even more than have been already implemented.” –Olivia S. Mitchell

Hard times may compel many to cast an eye on their social security benefits, but here again, they should consider the pros and cons, Mitchell advised. For one, the pandemic will also affect the Social Security Trust Fund, which is already projected to run out of money by 2032-2035, according to a PWBM analysis that explores various scenarios. “[The pandemic] just makes it worse for two reasons,” she said. “One, the decline in payroll, with people losing their jobs, will mean that revenue will be cut much sooner, much harder. Two, people who are in their sixties might be, out of desperation, needing to take Social Security early. So the benefit payments will begin earlier than anticipated.”

That’s a dangerous game, “because if you take your [social security] benefits early – [say] at 62 years of age instead of 70 – your benefits are going to be much, much smaller,” Mitchell noted. “If you delay until later, until age 70, your benefits would be 75% higher. But it may be [that] as a matter of desperation, that’s the best people can do.”

Further, if more and more people lose jobs in the coming months, the contributions to the Social Security Trust Fund will decline noticeably. “The thing that concerns me is that defined benefit pensions — both the few remaining corporate plans, and state and local plans — are in increasingly worse shape,” said Mitchell. “The fact that the capital market has done so poorly has really made much more difficult the underfunding issues in public plans.”

Moreover, the CARES Act has permitted delays in contributions to single employer defined benefit plans until January 1, 2021. “So anybody who was already facing underfunding is going to be compounding that in the defined benefit world,” she added. “There isn’t much room for complacency anywhere.”

Mitchell put those developments in the context of a larger trend of underfunding of pensions and state and local plans. “Before this crash, the estimate was that the state and local plans were underfunded by about $4 trillion dollars,” she said. “It could well be much higher now.” Alongside, states and local bodies will find their revenues falling short of projections as people lose jobs and cut spending on shopping, resulting in lower tax collections, she noted.

The real impact of those changes will show up only over a period of time. “It’s going to be a real debacle,” Mitchell said. “It will take a while to become evident because these pension plans don’t report in a timely way. Usually it will take a year before they report what their true funding status is. But you know it’s out there.”