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This month’s newsletter details several reasons why you should look for other sources of cash instead of tapping into your retirement funds, along with identifying potential tax surprises if you are using any of the pandemic-related relief programs, including unemployment benefits.

Think Before Tapping 401(k) as Emergency Fund

Do you need a quick infusion of cash?

Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, you may be able to take money out of a qualified plan, like a 401(k), or an IRA, with favorable tax consequences. But should you do it? You might view withdrawing money from a retirement account as a last resort.

Background

Among other changes in the CARES Act relating to qualified plans and IRAs, a participant can withdraw up to $100,000 of funds without paying the usual 10% tax penalty on distributions before age 59½. Plus, you can take as long as three years to pay the resulting tax bill, spread out evenly over the three years. If you repay the full amount within three years, you owe no tax.

To qualify for this program, you or your spouse must be diagnosed with COVID-19 or experience adverse financial consequences due to the virus such as being laid off, having work hours reduced or being quarantined or furloughed.

What are the pitfalls?

There are several reasons why you may want to avoid taking money out of your retirement accounts unless it’s an absolute emergency:

You’re diluting your retirement savings. Although the money comes in handy now, you’re chipping away at your nest egg and forfeiting growth. For example, if you withdraw the maximum amount of $100,000 that would have earned 6% annually tax-deferred for ten years, the value would have been $179,000.

It may be bad timing. Experts say it is difficult to time the markets in the current volatile environment. If you sell some holdings right now, you may be locking in losses that would miss the recovery in the next few months or years.

You still owe income tax. Income tax is due unless you replace the full amount within three years. Also, depending on your situation, you could end up paying tax at higher rates than you would in your retirement years.

Better options might exist. Arranging a hardship loan from your 401(k) might be a better alternative for your situation. You avoid the taxable event of the withdrawal and you pay back yourself with interest. Other options include refinancing a mortgage with lower interest rates, taking advantage of payment relief from mortgage, rent or student loan payments or deferred credit card billing.

While it is an option, retirement plan withdrawals are not always the best choice. Think through all scenarios before withdrawing from retirement funds to cover emergency expenses.

Be Prepared for Pandemic Tax Surprises

Numerous new laws provide economic relief to individuals and businesses hardest hit by this year’s pandemic. This much-needed financial assistance, however, comes with a few strings attached.

Here are three potential surprises if you use the available economic relief packages:

  • Getting a tax bill for unemployment benefits. While the $1,200 economic impact payments most Americans received does not have to be reported as taxable income on your 2020 tax return, there is currently no such luck with unemployment benefits. In addition to paying federal taxes on your unemployment compensation, more than half of states also impose a tax on unemployment benefits.What you need to do: See if your unemployment compensation check withholds a portion of your pay for taxes. Even if your check does have withholding for income tax purposes, the withholding amount may not be enough. If possible, talk to your state unemployment office and try to get withholding amounts revised.
  • Paying estimated tax payments. If you normally receive a paycheck from your employer, you may have never needed to write a check to the IRS to pay estimated future taxes. Your employer withholds your taxes from your paychecks and sends it to the IRS for you. If you’re collecting unemployment benefits, however, you may be required to pay tax on the unemployment benefits received during the first six months of 2020 by July 15, 2020.What you need to do: Estimate the amount of tax you owe for all sources of income, then compare that number with the amount of money withheld from your income to pay these taxes. If necessary, send in quarterly estimated tax payments to the U.S. Treasury and, in some cases, state revenue departments. This must be done each quarter with the next payment due July 15. You may need to send money in on September 15, 2020 and January 15, 2021 as well.
  • Reporting emergency distributions from retirement accounts: You may withdraw up to $100,000 in 2020 from various retirement accounts to help cover pandemic-related emergency expenses without incurring penalties. While you will not be required to pay an early withdrawal penalty, you will still be subject to income tax when filing your 2020 tax return.What you need to do: If you plan to withdraw funds from your retirement account, reserve enough of the money to pay the tax! The amount you reserve depends on your potential tax situation so call for a tax review before taking money out of the account.

The New Face of Banking

It suddenly just got a whole lot more difficult to buy a home

The banking sector is the latest industry to dramatically change how it operates in response to the current economic environment. The most visible change for consumers are new requirements for taking out a mortgage.

Here are some tips for working with banks and other lending institutions in the midst of tighter lending requirements and a heightened awareness of staying healthy.

Save more for a mortgage downpayment. New requirements for taking out a mortgage are requiring borrowers to put down at least 20% and have a credit score of 700 or better. Unfortunately, the average credit score of U.S. citizens under the age of 50 is below 700. The short-term reality is that you may need to save for a bigger downpayment and actively manage your credit before getting your dream home.

Take advantage of your bank’s mobile app. Social distancing is changing the way we interact in public and banking is no exception. Traditional bank tellers, drive through options, and in some cases entire branches, are being replaced with digital banking options and mobile deposits. This trend will surely accelerate in the aftermath of COVID-19. For the branches that remain open, visiting will likely be more restrictive. Smaller capacity banking spaces and appointments might be required to help banks control the flow of traffic.

Use digital payments for your purchases. While cash might still be king in the U.S. economy, consider using “germ-free” digital payments as retailers are steering customers toward electronic transactions. With businesses needing to adapt to new spending habits, innovation is going to steer towards digital payment technologies and make paying with cash more difficult in the future.

Look for lending deals. During these uncertain times, banks will be putting more effort into connecting with their customers. Bank leaders are making it a priority to personalize the banking experience with proactive marketing campaigns. Be on the lookout for special deals offered by lending institutions to help keep you as a customer.

As always, should you have any questions or concerns regarding your tax situation please feel free to call.