On March 27, 2020, President Donald Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (CARES) Act. Amidst the global COVID-19 pandemic, this act is designed to bring economic relief to individuals and businesses who’ve been affected by the resulting economic downturn.
Section 2202 of the act, titled “Special Rules For Use of Retirement Funds,” now allows those affected by COVID-19 to withdraw up to $100,000 penalty-free from their 401(k) or IRA.1
What does it mean to be "impacted by COVID-19?" Congress defines this broadly to include those who:
- Have been diagnosed with COVID-19;
- Have a spouse or dependent who has been diagnosed with COVID-19;
- Experience adverse financial consequences as a result of being quarantined, furloughed, being laid off, or having work hours reduced because of the disease;
- Are unable to work because they lack childcare as a result of the disease;
- Own a business that has closed or operate under reduced hours because of the disease; or
- Meet some other reason that the IRS decides to say it is OK.
This new option to withdraw from your 401(k) or IRA is on the table, but should you consider taking it? Below we’ll discuss what you need to know about this change and what to consider before making a decision.
Penalty-Free Access to Retirement Savings
Traditionally, there has been a 10 percent penalty for withdrawing funds from a 401(k) or IRA account before reaching the age of 59 ½. But through changes passed in the CARES Act, this penalty will be waived for individuals who choose to tap into their retirement savings accounts and withdraw up to $100,000 to cover financial burdens caused by the COVID-19 pandemic.1
If you choose to withdraw, you will have the option to spread the tax liability of this additional income over the next three years, and you will have three years to return savings (up to the full amount withdrawn) back into the account.1
But, what If you are concerned that the IRS might challenge whether you were "impacted by COVID -19" anytime during the first three years and argue that you did not qualify under the special rules and are not entitled to the COVID -19 tax relief on your 401(k) or IRA distribution? Well, you might consider returning the money rather that going to battle with the IRS. Under the rule you have the option to treat the distribution as a loan, before the end of the third year you might just simply return the distribution back to the qualified account and get a full tax refund of the tax payments you made over the three year period. With everything put back exactly how it was, the IRS might find it hard to dispute something that has been put back as it was before the COVID relief distribution.
I find some clients are often scared to take a deduction they are absolutely entitled to take because of fear that the IRS might look at their return more closely or even worse audit them. As a tax professional, we always want to be thinking about any possible way to mitigate the Client's risk in using new tax law before it has been tested and litigated and this might be an idea that almost gives you a do over.
Increase in 401(k) Loan Limits
Aside from withdrawing altogether from your retirement savings account, some plan sponsors offer the option of taking out a loan on your 401(k) or IRA. In the past, there have been limits on how much you can withdraw. According to the IRS, the maximum amount was previously “(1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.”2
In light of recent events, the CARES Act has adjusted this loan limit to a maximum amount of 100 percent of your vested account balance, or $100,000, whichever is less.1 This option will be available for individuals for 180 days after the CARES Act is enacted. Additionally, anyone owing a 401(k) loan repayment before December 31, 2020, can delay their repayment for up to one year.1
While the amount one can withdraw in a loan has doubled, it’s important to remember the IRS has not changed its rules on loan repayment. According to the IRS, “Repayment of the loan must occur within 5 years, and payments must be made in substantially equal payments that include principal and interest and that are paid at least quarterly.”2 That means that if you choose to take this option, you need to be prepared to pay the full amount back in substantial installments each year.
Considerations About Withdrawing From Your Retirement Savings
As is true for any other circumstance, the decision to withdraw from your retirement savings account early should never be taken lightly. Depending on your timeline toward retirement, $100,000 accruing compounding interest over the next couple of years could yield significant growth. In fact, the younger you are, the greater the dent you’re putting on your future retirement funds - if you choose to withdraw from your 401(k) or IRA without paying it back.
As you address the need for money now, remember to consider your need for money in the future. Is creating a significant reduction in your future retirement income the best option for addressing your present financial hardships, or would it be better to pursue alternative options - such as a personal loan, HELOC or tapping into your emergency savings?
But what if you don't need the money, you have met all of the requirements, and qualify to take the $100,000 distribution from your 401(k) or IRA... should you use this generous tax relief as part of your retirement tax planning strategy and begin to move your qualified retirement funds efficiently to non qualified accounts investing it the same way you would have inside your 401(k) or IRA only now you have removed part of the "tax lien" that the IRS has on all of our retirement accounts?
I know I am going against the text book answer here and the first chapter of the "IRA for Dummies" book, but when they passed the SECURE Act and it became law in January 2020, it drastically changed the way we help our clients plan for a secure retirement and to rethink how to best transfer wealth from one generation to the next.
I don't know about you... but for most of my clients, the best way is most likely an option that minimizes taxes, and when taking the 2020 Covid -19 tax relief distribution does that for my client, then I say with a resounding "YES" take advantage it! I say take advantage of most any of the tax relief that congress or the IRS might offer since it does not happen enough.
Before making a big financial decision like this, it’s important to work together with your Tax advisor. Please reach out and go over your specific situation so he or she can help you understand the long-term impact a decision like this can make on your financial future. You might find that it is a positive tax saving idea!
https://www.congress.gov/bill/116th-congress/house-bill/748/text#toc-H7E8FA907EAE04884809A56325BD425E5https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-loans#1