Posted By Jordon Rosen, CPA, AEP
Many Americans are taking a financial beating as a result of the COVID-19 pandemic. It’s bad enough that those with a retirement plan are seeing their retirement savings take a hit as the stock market has plunged from it’s February highs, but they are also suffering due to layoffs, reduced hours and pay cuts as businesses try to cope with shutdowns and the loss of business.
Last week, Congress passed the CARES Act (Act) which provides a host of provisions in an effort to put cash back in the hands of individual taxpayers who are struggling to pay for rent, utilities and food.
Section 2202 of the Act, Special Rules for Use of Retirement Funds, provides certain relief for affected taxpayers who may need to take early withdrawals from their IRA or employer’s retirement plan to cover personal expenses.
If an affected taxpayer makes a qualified COVID-19 withdrawal, the funds are not limited to COVID-19 related expenses such as medical bills. They can be used for any purpose, such as food, rent utilities, paying off credit cards or helping another family member or any other purpose for that matter. But take note – as I and other advisors have always stressed, and this cannot be emphasized enough – taking funds from your retirement account to pay current expenses should always be a last resort. This is important to consider not only since you are risking your future retirement funds, but also since you will be withdrawing funds in a down market, making it harder for your remaining retirement account to recover. If you must take funds from your retirement account, here are a few rules to be aware of.
The Act is fairly broad as to who qualifies for a COVID-19 related hardship distribution. To qualify, (1) you, your spouse, or a dependent must have been diagnosed with the COVID-19 or SARS-COV-2 disease or (2) you must have experienced adverse financial consequences as a result of being quarantined, being furloughed or laid off, or having work hours reduced due to the virus, being unable to work or only able to work reduced hours due to a lack of childcare due to the virus, or (3) being laid off or working reduced hours due to your employer being impacted by the pandemic.
COVID-19 Distributions from IRAs and Employer Retirement Plans
The Act allows any affected individual to withdraw up to $100,000 from their IRA or employer retirement plan (401K, 403B, and 457 plans) between January 1 and December 31, 2020, without incurring an early distribution penalty. The withdrawals can be made in a lump sum or in a series of smaller amounts, but not more than $100,000 in the aggregate among all qualified plans for each individual. A married couple, however, could each withdrawal up to the $100,000 from their respective plans.
To ease the tax burden of taking these distributions at a time when taxpayers will need the funds to pay basic living expenses, the Act allows affected taxpayers the option of either recontributing the funds back to their qualified account within a 3-year period or spreading the tax burden of funds not recontributed over 3 years.
Affected taxpayers who take qualifying distributions as described above have the option of recontributing the funds within 3 years which starts the days after the date that the funds were withdrawn. If recontributed within 3 years, the original distribution would be considered as if it were withdrawn and recontributed within 60 days and thus a tax-free rollover of funds. The funds can be recontributed back to any qualified plan (except a distribution from a traditional IRA or 401K plan could not be re-contributed to a Roth IRA or employer Roth account).
Spreading the Tax Over 3 Years
Many individuals will not be in a position to recontribute any or all of the funds they withdrew since they will still be recovering from the financial impact of being laid off or taking a pay cut. Funds that are not recontributed are taxed as ordinary income and can either be reported as such in 2020 or over a 3-year period beginning in 2020. If known at the outset that you will not be able to recontribute the funds, you need to prepare yourself financially for paying the tax on one-third of the amount withdrawn each year (2020, 2021 and 2022). Until further guidance is given to the contrary, this means that even if the funds are withdrawn on December 31, 2020, you need to be prepared to pay the tax on one-third of that amount on April 15, 2021. If you expect to be in a low tax bracket in 2020 and the next few years due to lower wages or business losses and can find a way to come up with the cash to pay the taxes, reporting the distribution in 2020 or over the 3-year period may not be too bad. However, repaying the funds to your retirement account is best, especially if you will recover financially after 2020.
This is too often overlooked. Some states will follow the federal rules allowing for tax-free recontribution of funds and/or the ability to spread the income over a 3-year period; but some states will not. Each state will make its own determination, so it’s important to know the rules of the state you live in.
Loans from Employer Qualified Plans
The Act also makes certain changes that loosen the restrictions on taking loans from an employer qualified plan, such as a 401K (loans are not permitted from IRAs). In general, a COVID-19 related loan can be made up to $100,00 or the present value of the nonforfeitable accrued benefit of the employee under the plan (the regular limits are $50,000 and 50% of the value of the nonforfeitable accrued benefit). The loan must be taken within 180 days after the effective date of the Act. In addition, any repayment that would otherwise be required in 2020 (along with subsequent payments in future years) of qualified loans is delayed by one year. The employer can rely on the employee’s certification that the loan (or early withdrawal as described above) is qualified as a COVID-19 distribution or loan.
We recognize and empathize with the struggles many individuals and businesses are going through during these challenging times. If you or your company have planning questions or concerns about the above, please do not hesitate to contact a BLS Team Member at 302.225.0600 or at email@example.com.
Jordon Rosen and your BLS Team