The coronavirus pandemic has upended the lives of people all across the world. Individuals and families are having to make adjustments to the way they go about their daily lives, educate their children and even shop for basic necessities. Unfortunately, the impact on the economy has also negatively affected millions of people who are now in need of financial relief. In an effort to provide aid, the CARES Act created a number of provisions in the tax code to assist US citizens who have been impacted by coronavirus.
One of the sections of the CARES Act that has been widely discussed deals with a special set of rules applied to retirement account withdrawals and loans made by "qualified individuals" in the year 2020. Today, were going to cover how these rules work, when they can be applied and a few scenarios where accessing your retirement account under the CARES Act might make sense.
Who Is Eligible?
As a part of the CARES act, qualified individuals who have been impacted by COVID 19 have been granted special allowances as it relates to retirement account distributions. Qualified individual means someone who has been adversely impacted by COVID-19. "Adversely effected by COVID-19" is admittedly a pretty broad list, so here is the wording directly from the IRS website. You are a qualified individual if:
- You are diagnosed with the virus SARS-CoV-2 or with the coronavirus disease 2019 (COVID-19) by a test approved by the Centers for Disease Control and Prevention
- Your spouse or dependent is diagnosed with SARS-CoV-2 or with COVID-19 by a test approved by the Centers for Disease Control and Prevention
- You experience adverse financial consequences as a result of being quarantined, being furloughed or laid off, or having work hours reduced due to SARS-CoV-2 or COVID-19
- You experience adverse financial consequences as a result of closing or reducing hours of a business that you own or operate due to SARS-CoV-2 or COVID-19
What Are the Special Allowances?
Retirement Account Withdrawals
For retirement account withdrawals, which typically are subject to a 10% penalty and income taxes, eligible individuals can make a withdrawal of up to $100,000 and avoid the 10% early distribution penalty. As for the income taxes, while they would still be due, the tax burden would be spread out over three years instead of being placed in one tax year.
If you're anything like me, an example would probably help drive this concept home. Let's say that John Doe is 50 years old, and a qualified individual under the CARES Act. He has retirement accounts totaling $200,000. Under the rules of the legislation, John can access up to $100,000 in total across all his accounts. Let's also assume that John earns $100,000 per year from his job as a professor at a local college. John decides he will indeed withdraw $100,000 from his retirement accounts before the year ends and the CARES Act rules no longer apply. In a typical year, John making a $100,000 withdraw from my retirement account before age 59 1/2 would mean a $10,000 penalty (10% of the $100,000 withdrawal), in addition to $100,000 being added onto his taxable income for the year. This addition would mean an increase in John's taxable income to $200,000 ($100,000 salary plus the $100,000 early retirement distribution).
However, because this is an allowable distribution under the CARES Act, John can take the $100,000 and avoid the $10,000 penalty completely. Not only that, instead of having the entire $100,000 withdrawal added to his taxable income in the year 2020, he will have only $33,000 added to his taxable income for each of the next three years (1/3rd of the $100,000 distribution). While this wrinkle does not allow John to avoid taxes on the distribution if he doesn't return the money, it does spread them out over a longer period.
If John does decide to replace some of the money, his tax situation gets even better. If John replaces money after he has already paid income taxes on these funds in a previous year, he can file an amended return and receive a refund for the additional taxes he paid as a result. For example, in the first two years of his three year window to replace the funds, John would have paid taxes on a combined $66,000 in income as a result of his distribution. If in the third year John makes a $66,000 replacement contribution to his retirement accounts, he can file amended returns for the previous two years and receive a refund for any taxes that he paid as a result of listing the additional $66,000 of taxable income on the two returns.
Retirement Account Loans
For retirement account loans, which are typically limited to the lesser of $50,000 or 50% of your account balance, the CARES act permits eligible individuals to take loans for 100% of their loan balance up to a $100,000 cap. If you’re interested, here’s more information on 401(k) loans, how they must be repaid and their taxable consequences.
Admittedly, an early retirement account withdrawal or a loan from a 401(k) or 403B is typically something I would look at as a last resort. I'm not in love with the idea of taking money out of the market, no matter how favorable the terms. That being said, you also have to make decisions in each area of your finances that taken in consideration your portfolio as a whole. There may be scenarios where doing something that has a negative impact on one account has a positive impact on your finances as a whole. Here are four scenarios where accessing a retirement account under the provisions of the CARES Act could prove to be beneficial
So Should I Take Advantage Of The New Distribution Rules?
Before we even address this question, my first recommendation is that if you are even considering utilizing these distribution rules, you need to meet with the tax advisor to first determine if you are indeed a qualified individual under the Act.
Even if you are a qualified individual, an early retirement account withdrawal or a loan from a 401(k) or 403B is typically something I would look at as a last resort. I'm not in love with the idea of taking money out of the market, no matter how favorable the terms. That being said, you also have to make decisions in each area of your finances that taken in consideration your portfolio as a whole. There may be scenarios where doing something that has a negative impact on one account has a positive impact on your finances as a whole. Here are four scenarios where accessing a retirement account under the provisions of the CARES Act could prove to be beneficial
1. A Financial Emergency
If you're in a situation where you simply don't have the cash in other accounts to pay for things you have to pay for, like food, shelter, electricity, etc., then some financial best practices may need to be thrown out the window. Don't feel like you're alone, because this pandemic has put many Americans in a financial bind. Accessing a retirement account with more forgiving rules on taxation and penalties may be preferable to putting money on personal loans or credit cards which you may have a tough time paying back even when things get back to normal.
2. You're Paying High Interest On Other Debts
This may sound crazy, but one of the more consistent themes I come across in my practice are clients who really shouldn't be contributing to a 401(k). The reason could be that they're putting money in retirement accounts when they don't have an emergency fund to speak of. It's great to have money set aside for the future, but if you have tons of money that you can't access until you're at least 59 1/2, but not enough cash on hand to cover a simple emergency, there's an imbalance there. For the sake of this example however, you might also consider pausing retirement contributions or withdrawing/taking loan money under the CARES Act if you're paying more in guaranteed interest on debt than you can reasonably expect to earn on your investments in the market. If you have thousands of dollars in high interest debt (e.g. credit cards, personal loans), it's worth calculating the weighted average interest rate on all of your debt. Let's say that you have $40,000 of high interest debt with a weighted average of 12% per year. While there may certainly be periods where the money you have in the stock market will exceed 12%, it certainly isn't a return that you should expect year after year. Depending on the balance of your retirement accounts, the interest accruing on your other debts and even the monthly payments that must be paid towards those debts, you might find that using a retirement account withdrawal to pay them down or pay them off completely could put you in a more secure financial position.
3. You're Positioning Yourself For A More Preferable Investment
I say a more preferable investment because calling something a better investment is often a subjective statement. Let's say that you've wanted to open your own business, dip your toe into investment real estate or any other venture that you thought it might take years before you were able to pursue it. The ability to withdraw or take a loan from a retirement account with more favorable terms opens up a pool of funds that could have a lower opportunity cost than trying to finance your dream investment through a loan. I often ask my clients how they want to pursue wealth: some are comfortable working in secure jobs with great benefits that allow them to simply save their way to wealth through retirement account contributions and traditional savings. For these people, the idea of withdrawing money from a growing retirement account to pursue a business venture is horrifying and likely an ill fit for their goals. We have other clients who may be in stable jobs now, but they long to pursue wealth through independent ventures, entrepreneurship and passive income. For them, a 401(k) or another retirement account can at times seem like a useless pile of money when it comes to the achievement of these goals. Why? Because the funds are working on their behalf, but not in a way that allows them to reach their goals. If you feel like accessing your retirement accounts can bring you closer to the type of wealth building that you would find fulfilling, it's worth considering.
4. You're Pursuing Homeowership In An Expensive Market
There are multiple forms of mortgages for which you can apply when buying a home. Depending on the mortgage type, you could be required to contribute a down payment of anywhere from 0% to 20% of the home value (0% down payment loans are typically reserved for physicians and dentists pursuing a type of loan called the Physician Loan). For first-time homebuyers, government-backed mortgages are often available that allow them to purchase a home with a down payment of 3.5%. For homebuyers who aren't purchasing for the first time, a 10% down payment may be the minimum acceptable down payment. If you're in an area with a low cost of living, coming up with 10% of your home's value as a down payment may not be much of an issue. As an example, putting aside 10% for the down payment on a $200,000 home would mean saving $20,000. Not easy, but not impossible either. But there are some markets where saving even a 10% down payment is a tall task. If you live in San Francisco and can barely find a home that's safe for less than $1 million, a 10% down payment means saving at least $100,000, and you could have to pay another $20,000 or so just in closing costs. Recognizing that this is a significantly tougher hill to climb, companies have started popping up in expensive markets like California and New York that will pay a portion of a home down payment in exchange for a percentage of ownership in the property. These are often loans that must be repaid over a period of time, and if the homebuyers sell before the lender has been paid out, the lender will receive a portion of the home sale proceeds based on their percentage of ownership (e.g., if the company is a 30% owner of a home that you sell for $100,000 profit, they would receive 30% of the sale proceeds). Faced with options such as these, an interested homebuyer with the ability to take out a 401(k) loan might decide that they would rather use their own retirement account as a funding source and pay back their own retirement fund over time, rather than waiting until they save the money in other accounts (when home prices might be higher), or receiving down payment assistance from an outside party that might have to be repaid.
We don't know how long the pandemic will last and what the long-term ramifications will be to our economy. When faced with a confusing set of circumstances and not knowing what the future will hold, the best we can do is make sound decisions with the information we have at hand. I hope that this overview gives you some of the tools you need to make these decisions, and here's hoping that what's ahead is better than what's behind us.