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In normal times the tax law restricts access to retirement funds for nonretirement purposes. These are not normal times. Two major changes that will free up cash for current expenses are the waiver of certain penalties for withdrawing from an IRA or 401(k) distribution and an opportunity to take enhanced plan loans. However, the devil is in the details. And whether you should avail yourself of the opportunity depends on your unique circumstances.
Taking money — what the law says for sure
The coronavirus stimulus, formally called the CARES Act, allows you to withdraw up to $100,000 from a retirement account (IRA, 401(k), etc.) and you won’t have to pay a 10% penalty even if you’re not 59½ years old. As of now the law makes it clear that you can only do this if you have something called a “coronavirus related distribution” (CRD).
In addition to avoiding the 10% penalty, you will be eligible to pay the ordinary income taxes on your distribution over three years (but you may elect to pay it all at once). So, for example, if you take out $30,000 and you are in the federal bracket of 24%, you will owe $7,200 in taxes for accessing your money (or $2,400 a year). Once you recover financially you will have three years from the day after you take the distribution to pay it back to your IRA or employer plan if you choose to restock your nest egg. If you recontribute funds, you won’t be limited to IRS rules that constrain annual contributions because your repayment (can be one time) or repayments (can be many payments over the three year period) will be treated like a rollover, and rollovers were never subject to the pesky rules limiting plan contributions.
It is important to note that you are not required to recontribute funds. In fact, financial planners may suggest that even if you are inclined and able to restore savings you recharacterize your retirement savings, so they are in position to get Roth treatment.
A CRD is any distribution by a person who has been diagnosed with COVID-19 (or SARS-CoV-2), their spouse or dependent. In addition, even undiagnosed people can take a CRD if they have adverse financial consequences because of being quarantined, furloughed, laid off, given reduced hours, or were unable to work because of child care responsibilities brought about by the current crisis. In addition, business owners who have closed the business or reduced hours also are eligible for a CRD.
Read: Why this bear market isn’t all bad news
Borrowing money — what we know
Traditionally loans from employer plans were limited to $50,000 or if lower, 50% of your vested account balance. The CARES Act increases that amount to $100,000 or if lower, 100% of your account balance. The increased limits are applied for six months beginning March 27, when the bill was signed. The law allows you to suspend any loan repayments until next year. It extends the normal repayment period from five years to six years. The loan rules also are only available if you are entitled to a CRD.
Taking or borrowing money — what we don’t know
At this point we are not 100% sure what the child care exception might entail (we discussed the basics for CRD above, however, further interpretation is sure to come to help clarify the current language). We are waiting IRS direction regarding additional circumstances that may be counted upon to qualify for a CRD. You also may need to wait to see if your employer’s plan will allow you to draw down funds. But you won’t have this concern if your funds are in an IRA. In addition, there are no loans from IRAs, and you may have to wait to see if your employer will adopt the enhanced loan rules. In addition, you will need to check whether your employer provides plan loans at all. There is no legal requirement that they do so. Finally, we don’t know yet what consequences taking a withdrawal will have on your state taxes.
Read: 401(k) investors may be tougher than you think
Should you use retirement funds?
There is no right answer for this question. If your ship is sinking, you will need to lower the life boats. If you can avoid raiding your retirement fund, the financial planning professor voice in my head says to leave those funds alone. Particularly since the market value of the retirement fund has probably just taken a huge hit owing to recent market declines and you may be liquidating funds and locking in your losses. Here are other important considerations:
• Any funds taken out via loan might be “out of the market” and miss out on a potential recovery after this crisis has passed.
• Any funds withdrawn and used to pay current bills will also miss any potential recovery.
• There may be a time in the near future where you can use the withdrawn or borrowed funds to tax-effectively perform a Roth conversion.
• You will need to reassess your situation depending on the length and/or recurrence of the Covid-19 crisis.
• You can almost count on IRS regulation and future legislation being another factor that will impact your decision.
Read: Is this the retirement apocalypse?
What next?
At this time, it may be prudent to assess your options. Give your employer a few days to sort out the new rules and then email them to see what your employer plan allows (or when you will know what your plan allows).
Keep looking for further guidance regarding whether you are eligible for a CRD. Talk with your planner to see if they have any advice about which options are best for you. You can both decide about issues of how much to withdraw, whether to take a loan instead of a withdrawal, whether the ratable tax payment for three years opens up any opportunities, or whether you may take funds out now with the intent of repaying them over three years.
You also will need to assess whether delaying the repayment of a plan loan is a smart strategy.
And finally, you will want to get advice on the state income tax burden you may have if funds are withdrawn.
