In March, U.S. lawmakers passed a coronavirus relief and stimulus package to help Americans weather the economic shutdown.
While the legislation’s promise of $1,200 cash payments to workers drew most of the attention, changes that make it easier for people to take early withdrawals and loans from retirement accounts could have a far bigger impact.
These well-intentioned overhauls are aimed at giving Americans a way to pay their bills until the current downturn subsides. That makes sense, especially if it prevents people from using expensive credit cards or payday loans to stay afloat.
But making it easier for people to tap their retirement savings—without offering them guidance on the most prudent way to do it—could lead some workers to make poor choices that diminish their financial security well into the future.
While the complete set of changes in the new law is complex, the legislation, known as the Cares Act, makes the following key ones:
The law temporarily waives the 10% penalty on early withdrawals for Covid-19-related reasons, and eliminates the taxes on such withdrawals if the money is paid back within three years. It doubles the maximum amount permitted for a loan, to $100,000 from $50,000, and doubles the percentage limit to 100% from 50% of the total account balance. And the law waives for 2020 the requirement that people older than age 72 take distributions from their tax-deferred retirement assets.
Deciding whether to take advantage of these overhauls—which aren’t mandatory but which most employers are expected to follow—will require workers to weigh a long list of trade-offs and uncertainties. Behavioral economics suggests that if they get overwhelmed, they might give up and rely on costly debt instead.
But behavioral economics also offers a solution: People are more likely to make the decision that is in their best interest if it is easy. There is no better nudge than the path of least resistance.
To that end, I have created a set of simple guidelines—rules of thumb, if you will—to help workers navigate their finances in the era of Covid-19. These guidelines aren’t perfect, but they will make it far easier and less stressful for workers to take advantage of the Cares Act without ruining their chance at future retirement success.
The first difficult decision faced by workers who are forced to pull money from retirement savings is whether to take a hardship withdrawal or loan. The withdrawal might seem to offer the best of both worlds under the new law. It doesn’t have to be repaid—but if the worker can repay it within three years, he or she will get a refund on taxes paid. A loan, on the other hand, must be repaid on a fixed schedule.
The flexibility associated with the withdrawal, however, is likely an illusion. That’s because retirement plans don’t have automated repayment systems for withdrawals like they do for loans. Instead, workers will have to remember to send checks or payments on their own, and behavioral research tells us most are unlikely to do so.
What’s more, claiming the tax benefit for repaying Covid-19 withdrawals is likely to require a professional accountant, as workers will be seeking a credit for taxes they’ve already paid.
Therefore, if you are serious about putting back whatever amount you pull out, go with a loan because it makes repayment easy. (You also have more years to pay it back.) If you don’t think you’ll repay, or if you are likely to lose your job, use the Covid-19 withdrawal.
That said, employers should still set up auto-payment systems to help people pay back their withdrawals.
After deciding between a loan or a withdrawal, the next question is how much to pull out. To make it easy, I propose this general guideline: Take half of what you think you might need.
To understand why “take half” is a valuable nudge, it’s important to understand how most people settle on financial numbers, whether it’s an initial savings rate or a loan amount. Research that I conducted with Nobel laureate Richard Thaler suggests that many people rely on mental shortcuts when making difficult financial decisions instead of considering their actual needs. For instance, we found that people were nearly 20 times as likely to select 10% as a savings rate rather than 9% or 11%. Why is that? Because 10% is an easy round number to consider. This tendency could lead some workers to take out the maximum permitted under the Cares Act simply because it is easy.
By following my “take half” rule, you will preserve more of your nest egg and maintain the option of taking out the second half at a later date. And considering that most Americans have significantly cut back their spending during the shutdown, you might not need the money.
The only potential problem with this approach is that some employers don’t let plan participants take out multiple loans. Companies should consider lifting this restriction to discourage workers from taking out larger loans, just in case they need the money.
What about those who decide against a loan or withdrawal but want to cut back on their savings rate to preserve cash? Try to save at least save the minimum needed to get the maximum employer match. In other words, don’t leave money on the table.
Once the current crisis subsides, workers will need to focus on rebuilding their savings, including those who reduced their savings rate to preserve cash. That means re-enrolling in a retirement plan and committing to gradual but steady increases in contributions at some point in the future.
For those wondering how best to play catch-up, I suggest you default to the following: Go back to your precrisis saving rate next year, then increase that rate 2 percentage points annually until you reach 15%, the new cap under a new law known as the Secure Act.
You can set up a basic version of this nudge on your own, putting a reminder in your calendar to increase your savings rate next year, or on your next birthday. Research shows that people are particularly likely to take steps to achieve a goal during certain temporal landmarks that represent new beginnings, whether it’s a birthday or new year. This is known as the fresh start effect.
Of course, it’s a lot better if employers and plan providers create autopilots for these interventions, making it easy for people to commit to save more with a single click. Most already offer a version of the “savings escalator,” but every employer should.
Companies also could encourage employees to save at a higher rate in the future by implementing a “stretched match.” For example, instead of offering 50 cents on the dollar up to 6%, they could offer 25 cents up to 15%. In the short-term, this will save companies money. In the long run, it will encourage workers to save more and demonstrate a commitment of the company to their retirement success.
Unfortunately, millions of workers won’t be able to keep saving with their current employer because they have lost jobs due to Covid-19. These Americans are facing perhaps the hardest decision of all: What should they do with their old retirement accounts?
Generally speaking, when people change jobs, about a third of workers keep the account with their old employer, a third roll it over to an IRA, and a third cash it out.
My rule of thumb for the newly unemployed is to keep your retirement account where it is. You often benefit from lower investment-management fees and it is the path of least resistance. However, if you want to mentally “close the chapter” with your old employer, and you don’t need the funds right away, it’s definitely better to roll it over than cash out.
Be aware, however, that our current system almost always makes it easier to cash out than roll it over. This is backward. Given the need for savings, companies and plan providers need to make rolling over a retirement account as easy as cashing out.
My last rule of thumb is aimed at retirees who are debating whether to skip their required minimum distribution, or RMD, for 2020.
If you don’t need the money—and you may not, since many Americans have cut back on spending amid the current crisis—don’t take it out this year. I’m not recommending this because of recent market performance or trying to time the market. Rather, it’s because skipping your RMD this year means you will have more later, and thus reduce the very real risk of outliving your assets.
If you need the money, I recommend taking it out little by little, perhaps every month or quarter, to avoid the potential regret of selling assets near the bottom of a correction.
One day, the Covid-19 pandemic will be a distant memory. However, the financial decisions we make during this crisis will have long-term consequences, potentially reducing our financial security well into the future. Unless we give people clear and simple recommendations, and make it easy for them to follow, our well-intentioned reforms might backfire.