In life, priorities can change quickly, without warning. Sometimes plans for the future must be adjusted for immediate needs, and a short-term crisis forces one to access not only rainy-day funds, but also more substantial funds that were otherwise earmarked for retirement.
Retirement funds such as IRAs or 401(k)s grant tax advantages to savers, but also have special rules one must follow to preserve those benefits. Drawing on them before retirement age (59 ½) can incur a dual penalty – a 10% haircut on the funds, and the loss of tax-preferred status of withdrawn funds for future growth. There are ways to draw on that capital without incurring as much of a penalty, and the CARES Act has relaxed some of the rules to provide expanded options for those affected by COVID-19.
Specifically, these relaxed rules are available to any taxpayer who tests positive for COVID-19 or whose spouse tests positive as well as someone:
- Who was quarantined, furloughed, laid off, or had reduced hours because of the disease;
- Was unable to work because of lack of childcare;
- Who had closed or reduced hours of a business owned by the taxpayer because of the disease; or
- Other factors that may be identified by the Treasury Department.
How did the CARES Act change access to plan loans from a 401(k)?
People can borrow funds from their 401(k) plan or qualified retirement plan if they are experiencing financial difficulty. Normally, one would be able to borrow up to 50% of their vested balance, to a maximum of $50,000. These caps are doubled for certain loans made from March 27, 2020, to September 23, 2020, to a maximum of $100,000 or 100% of the vested balance. Repayment of the loan may be deferred until January 1, 2021, when a five-year amortization must begin.
Why do it this way?
By taking out a loan from yourself instead of asking for a distribution of the funds, you give yourself the opportunity to pay the loan back to yourself with interest and avoid the 10% penalty tax on the funds, avoid the income tax associated with a distribution, and preserve the tax-preferred status of the funds when the loan is repaid.
What do some people miss?
Just as hardship caused the need for the loan, in some cases a further hardship may cause the immediate need to repay the loan. Normally, if you leave the company, the loan will need to be paid back immediately or would be considered defaulted. Because the loan is from and to yourself, it would not affect your credit score; however, the tax status would change from a loan to a distribution. This would not only create additional income tax based on the outstanding balance that year but would also make the funds subject the 10% penalty tax if you are not 59 1/2. The CARES Act allows deferment on the repayment of the loan of up to a year after the funds are dispersed.
Loans are not permitted from IRAs or Roth IRAs, but a coronavirus-related distribution (CRD) is allowed that has some of the same benefits.
What is a Coronavirus-related distribution?
An alternative to the loan is a distribution, which is permitted for the same “qualified individuals” as the expanded loan provision. Up to $100,000 may be distributed from either an IRA or an employer sponsored plan.noticeWhy do it this way?
There will be no 10% penalty on premature distributions if the account owner is younger than 59½, even if nothing is repaid. The taxpayer does have the option to repay the distribution and reclaim the tax-preferred status of the funds.
The taxpayer may elect to repay the coronavirus-related distribution over three years and avoid the income tax associated with the distribution eventually. Such repayments will be treated as if they were trustee-to-trustee transfers and similarly to the loan repayments, they will not affect the taxpayer’s right to make future normal retirement plan contributions.
What do some people miss?
The distribution will be subject to income tax, which could be substantial given the tax bracket and size of the loan. The income tax may be paid in full for the 2020 tax year, which could be the best choice if the taxpayer has fallen into a low tax bracket, or the distribution may be treated and taxed as if it were received 1/3 in 2020, 1/3 in 2021, and 1/3 in 2022. Deferring the tax bill is tempting, but one may be in a higher tax bracket in two years. The state income tax treatment of the distribution may not match the federal rules.
The Income tax will be due immediately (within the proportion elected), and then refunded if the money is recontributed. This means that you will need the take on the income tax liability (or proportion thereof) until the contribution is repaid, which could be substantial.
What other considerations are there?
Although these additional options for affected taxpayers are helpful, invading retirement resources should be considered a last resort, especially when stock prices have fallen substantially. Taking a distribution when values are low may amount to locking in a loss and losing the opportunity to capitalize on the recovery.
An important consideration for those that are drawing on their retirement funds should be what assets to sell. Should stocks be sold while their asset values are low, or would it be better to sell bonds? How can the tax-deferred status of particular investment vehicles be leveraged to provide the right amount of risk given your entire financial picture?
A professional client advisor, such as those at Arvest Wealth Management, can help review your families’ investments and create a holistic planning picture and risk assessment. This is a good way to figure out the pros and cons of what the best choice would be for your unique situation and family dynamic.
This content has been provided by Merrill Anderson and is intended to serve as a general guideline.
© 2020 M.A. Co. All rights reserved.