As businesses and individuals continue to experience the financial impact of COVID-19, taxpayers might be considering tapping into their tax-qualified retirement accounts; either to keep their businesses operating, or to meet personal cash needs. Certain provisions of the Coronavirus Aid, Relief, and Economic Security (CARES) Act made this strategy more accessible for taxpayers.
Business owners, plan administrators, and individual taxpayers considering such a move should familiarize themselves with the CARES Act’s special rules, plus the general advantages and disadvantages of using retirement accounts to manage temporary cash shortfalls.
Basic Facts to Consider
There are many reasons financial advisors caution against using retirement funds to meet short-term needs. Beyond missing out on potential investment gains their accounts might achieve, taxpayers who withdraw funds from tax-qualified plans before reaching age 59½ also incur significant tax penalties.
Taxpayers with employer-sponsored accounts such as 401(k) plans can avoid immediate tax penalties by borrowing from their accounts, instead of taking early withdrawals. (Loans cannot be taken from IRAs.) Such loans must be repaid within strict deadlines to avoid being reclassified as an early withdrawal.
Despite these concerns, taxpayers might find it necessary to take cash from their retirement accounts to address coronavirus-related financial pressures. Section 2202 of the CARES Act was designed to make this somewhat easier.
Eligibility for New Rules
The CARES Act special distribution rules are available only to taxpayers adversely affected by the pandemic in at least one of the following ways:
- Diagnosed with COVID-19 or has a spouse/dependent diagnosed;
- Suffered adverse financial consequences from being quarantined, furloughed, laid off, or reduction in work hours;
- The virus has caused a lack in childcare, and therefore cannot obtain work; and/or
- The individual was forced to close or reduce hours of a business he/she owns or operates.
IRS Notice 2020-50 expanded this list to include self-employed workers and taxpayers with other household members who suffered any adverse financial consequences listed in the Act.
CARES Act Changes
For those meeting at least one of these qualifications, the CARES Act waives the 10% penalty normally imposed on early distributions from retirement plans. Distributions must still be reported as income, but qualifying taxpayers may report income over a three-year period, vs. in entirety the year the distribution was received. Furthermore, if taxpayers repay their distributions within three years, they can treat the distribution as tax-free transfers and request refunds on the relevant taxes. These distributions must be taken before December 31, 2020 and are limited to $100,000 per taxpayer.
The CARES Act relaxes rules regarding loans from employer-sponsored plans. For coronavirus-related loans, it extends all payment due dates between March 27 and December 31, 2020 by one year, and adjusts subsequent due dates accordingly. This effectively gives qualifying taxpayers six years to repay a new loan instead of five. An earlier rule change previously gave taxpayers additional time to repay loans if their employment was terminated.
The Act temporarily increased the maximum amount that could be borrowed from a qualified plan, but that provision expired in September. The maximum loan amount has now reverted to $50,000 or 50% of the vested account balance.
The Employer’s Role
Just as employers are not required to allow loans from their 401(k) plans, they also are not required to adopt CARES Act changes. However, even if an employer-sponsored plan is not amended, a qualified taxpayer can still treat a COVID-related distribution as eligible for the CARES Act tax benefits.
Account holders do not need to prove the extent to which they were adversely affected by the coronavirus. Therefore, plan administrators do not need to review bills or receipts to determine the qualifying amount of a loan. Instead, employers may simply rely on the employees’ certification for eligibility.
Employers who are considering whether to adopt the new rules—and individuals who are wondering whether to take advantage of them—should carefully consider all pros and cons before making their decision.
Our team is available to help. Please contact your Mueller Prost specialist to learn more about your retirement plan options.