As part of the 2020 Cares Act, my wife and I both took maximum withdrawals from our 401k accounts. Why did we do this, and why are we planning to put it (mostly) back?
First, let’s start with the what. My wife got a 20% reduction in pay for several months of 2020 as part of her employer’s plan to reduce costs to help “weather the storm” of COVID-19. This is one of the criteria to qualify for a 2020 Care Act withdrawal, which is a special case of a hardship withdrawal. Generally, one cannot withdraw funds from a 401k before age 59 1/2 without paying both tax AND a 10% penalty. The tax makes sense, since these funds were pre-tax dollars, but the penalty hurts. The 2020 Cares act allows a maximum withdrawal of $100K per person, without having to pay the 10% penalty! This was a chance to access our tax sheltered funds, so each of us did this and we got $200K, minus $20K in federal tax withholding and some additional state tax withholding.
Note, as I’ve seen more recently with my adventures in Turbo Tax, this was evolving in real-time. We took the withdrawal from my wife’s 401k in May 2020. It wasn’t clear at that time if I could take a withdrawal too, since it only called out the person, not their spouse. It was later clarified and expanded to include the spouse for eligibility as well, but I didn’t take my withdrawal until later in 2020.. Here is the thread I contributed to on Turbo Tax communities when I was trying to find the answer to this.
The conventional wisdom is not to touch any retirement funds until you need them. This will help ensure people save enough for retirement. In our case, we have saved a decent amount, although we may not be ready to retire according to our plan just yet. One thing that would help us retire early is having more funds invested in taxable accounts like our brokerage account with TD Ameritrade as well as our Real Estate investments with Fundrise.com. As discussed in another article, we are trying to build our passive taxable income to bridge the gap before we can access our tax-sheltered funds in our 401Ks and Roth IRAs.
We did not start focusing on our taxable accounts until the past few years, so our passive income from these sources is only a little more than 10% of our total passive income. If we increase our taxable passive income, it is available “now” to pay our expenses until we can start tapping our tax sheltered accounts at age 59 1/2. There are methods to tap tax-sheltered funds before 59 1/2, so we will consider those as well.
Our thought was to use some of the withdrawn funds to supercharge our taxable account investments to speed up this process. We also wanted to have flexibility and cash on hand in case we did some home improvement projects or to help with tuition (my daughter is a Junior in high school this year!). The advice to not touch your retirement savings is valid, but essentially this was an opportunity to rebalance some of our tax-sheltered nest egg into our taxable nest egg. Through all of this, we are still maxing out our 401ks and our Roth IRAs too.
So why are we recontributing the funds? Well, we will definitely recontribute some, but with the 2020 Cares act withdrawal, by default we spread the income over three years. Since $10K was withheld, our increased taxable income for 2020 would be approximately $30K each or $60K total:
- $100K withdrawal – $10K federal tax withholding = $90K
- $90K/3 years = $30K per year ($60K for both of us for 2020, 2021, and 2022)
We can “recontribute” the funds through an after tax rollover, which will reduce our taxable income. If done before filing taxes for that year, it is accounted for within that tax return. If done afterwards, it would need to be adjusted through an amendment to a prior tax return. The additional income will bump up our taxable income significantly, so we will recontribute to reduce the tax liability. Since it’s over a 3 year period, we can adjust how much we pay back in 2021 and 2022, but already moving forward to pay back the 2020 withdrawal in full.
I went and got cashier’s checks from the bank today (2/27/2021) to recontribute $30K each, so our increased taxable income for 2020 on the withdrawal should be 0/minimal. Incidentally, I started my return in Turbo Tax, and the required forms haven’t been programmed correctly yet, so it says we currently owe $65K+ in taxes. Yikes! It is not spreading the withdrawal over 3 years, and it’s not accounting for our recontribution yet. Owing $65K in taxes would be a LOT for us, haha. It’s funny, as long as we can get it straightened out… Remember above where I said this was a evolving in real time? Now that it’s almost March, I’m hoping it is resolved very soon.
In the meantime, we have additional cash if needed or just to help fund our aggressive savings budget. We can “park” the money in short term investments to earn some return as well, while remaining liquid “enough”. On a side note, my wife’s employer is also paying back the 20% reduction from last year, so we’ll have more cash on hand. Since our funds have always been so tied up in retirement investments, it’s nice to have some available if necessary. Our retirement accounts have continued to perform well . With the continued bull market, my 401k balance is back above where it was before I took out $100k, and we’ve been able to increase our taxable nest egg and get closer to our financial independence goals.
My wife will have a higher than normal income for 2021 due to the repayment of the wage reduction in 2020, so we will almost certainly recontribute the next share of our Cares Act withdrawal (another $30K each), but we’ll see how it goes for 2021 and 2022. Having flexibility and choices is great for us, even if it doesn’t align with conventional wisdom. Another aspect of Financial Planning is that we have to consider our own unique circumstances and do what makes the most sense.
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|Disclaimer: I am not a financial planner and content on this site is meant to provide food for thought, not professional advice. I share my experiences to show what worked so far and what didn’t, YMMV. Please consult your financial advisor or tax professional as needed.|