Recovery tales: Clean up after COVID withdrawals

When you are down to your least-best options, you can still get back on your feet.

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Key takeaways

  • Taking an early withdrawal from your retirement funds can set back your plans, but it doesn't have to derail them completely.
  • If you have a financial plan, you can stress test your options to see what works best for your financial situation, and what you need to do in the future to get back on track.
  • If you took a withdrawal in 2020 under the CARES Act rules, make sure to file your tax forms correctly.

Taking money out early from your retirement accounts is one of the third rails of financial planning. But what if you really need to?

That's what happened to a lot of Americans in 2020, including some 1.6 million Fidelity customers who took out an average of $9,400 from their qualified retirement accounts under rules loosened by the CARES Act. The temporary easing in 2020 allowed people younger than 59½ to withdraw up to $100,000 from accounts like IRAs or 401(k)s without paying a 10% penalty, and also let people pay back or spread the income tax burden over 3 years.

Clean up your CARES Act withdrawal

Tax forms for CARES Act withdrawals are due with 2020 income tax returns.

Use your Fidelity-provided 2020 IRS Form 1099-R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) to report the amount of any CARES Act withdrawals on IRS Form 8915-E (Qualified 2020 Disaster Retirement Plan Distributions and Repayments).

More information is available here.

Options include:

  • Pay back all or some of the money.
  • Spread the taxes out or pay them all now.
  • Pay the full tax amount owed and don't pay back the money.

What you decide to do depends on your overall financial situation, which you may want to discuss with a tax professional.

"Every hardship withdrawal comes with a story, but none of them are without hope," says Eliza Badeau, vice president of thought leadership at Fidelity.

Indeed, there are many ways to recover from a retirement setback. Shannon Holz, a vice president, financial consultant for Fidelity from Cleveland, had one client who is now back on his feet after needing to take out close to the $100,000 limit in 2020, and some the prior year before the pandemic started. The man, in his mid-40s, had left his job strategically to get training in order to change career paths. He had been close to a job offer when the economy shut down last March, but it fell through just as his wife's hours got reduced.

Holz's client didn't get another job until the fall, but is now back to contributing again to his retirement account. Because of growth in the market, he's only about $25,000 behind where he was, despite all of his withdrawals. While he missed out on investing new retirement contributions over the total of 18 months he was taking money out, he's got greater potential going forward because he's on a new trajectory where he can make more and save more going forward.

"He's pretty happy now,” says Holz. "Overall, he's in a good position."

Holz's client had a couple of advantages going into the process. The biggest one is that he started saving early in his career and kept it up consistently. He had amassed a healthy nest egg by his early 40s—much more than the Fidelity average retirement balance, which was $120,000 at the end of 2020, according to company analysis. Another is that he had a financial plan in place and tested out his options before he took his withdrawals, so he knew how much he could afford for retraining and still have a good chance of a successful retirement.

Holz's other clients who took retirement withdrawals in the last year had a variety of needs, from helping children who were having financial troubles to home renovations.

"They were kind of using it the same way you'd use a home equity line of credit," says Holz.

Some were planning to pay the money back over the 3 years allowed by the CARES Act, while others, mostly close to retirement, were planning to just pay the income tax on the withdrawal and adjust accordingly.

For anyone who took a withdrawal under the rules of the CARES Act, you can look at your overall financial picture and see what approach works best for you. The most important thing is to decide by the time you file your 2020 tax return and make sure to file the proper forms.

Financial emergency? Consider all your options.

Life happens and it can sometimes be unexpected and expensive. What do you do if you have a financial hardship, like unexpected expenses such as a medical issue or reduction in pay? How can you act quickly and still make sure you can pay in a way that doesn’t derail your entire budget?

Before exploring these emergency options that could increase your debt, consider what else may be available to you, like a payment plan option or consolidation services.

Is this a medical emergency? Consider using your health savings account (HSA) or flexible spending account (FSA) for qualified medical expenses if you have one. If you don’t have an HSA or FSA, don’t have enough to cover the cost in full or this isn’t health related, follow the path below.*

Here is a flow chart of which accounts you should consider for emergency withdrawals.

*This hierarchy was created with the goal of minimizing the adverse effects of an emergency withdrawal such as unexpected or unplanned taxes, penalties, or impacts to other planning goals. This information is intended to be educational and is not tailored to the investment needs of any specific investor. Hardship distributions are taxed as ordinary income and may be subject to a penalty when you file your income taxes.

Being in an unexpected financial squeeze can seem hard to recover from, but this could be a good time to take a look at your day-to-day expenses and see where you can make some adjustments and save a little extra cash.

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