June 23, 2020
The $2 trillion CARES Act included a provision that made it easier for taxpayers to take out loans and withdrawals from qualifying retirement accounts without the risk of paying the 10% early withdrawal penalty, and with the ability to repay these withdrawals within a certain timeframe.
While the IRS has addressed this topic in previous announcements and FAQs, they released the formal guidance for this on Friday. You can find it in IRS Notice 2020-50, Guidance for Coronavirus-Related Distributions and Loans From Retirement Plans Under the CARES Act.
Brief Overview of the New Retirement Account Withdrawal Rules
The new law applies to those who have experienced “adverse financial consequences” due to the Covid-19 outbreak.
Under the new law, taxpayers are eligible to borrow up to $100,000 from their 401(k) plan, an increase from the $50,000 previously allowed.
The law also permits individuals to take up to $100,000 as distributions from their IRAs or 401(k) plans in calendar year 2020. This $100,000 limit is a cap across all retirement accounts, not from each type of account. The 10% early withdrawal penalty is waived for those who are under age 59½.
Individuals are still required to pay taxes on the amount withdrawn, however, they would have the option of paying taxes over a three year period.
Finally, individuals would have the option of repaying the distribution into their IRA, 401(k), or another eligible retirement account if they cannot repay the amount into the account they took the distribution from. This would be performed as a rollover contribution and must be accomplished within three years of the distribution. The distributions that are repaid as rollover contributions will no longer be subjected to taxes and you would need to file an amended tax return for the IRS to process your rollover contribution.
Definition of Qualified Individuals
This law is designed to provide financial assistance to those who have experienced financial hardship due to the Covid-19 pandemic. So this is not a free-for-all designed for anyone and everyone to withdraw money from their retirement accounts.
Qualified individuals are those who have experienced adverse financial consequences due to any of the following circumstances:
- Individual, spouse, or dependent who was diagnosed with Covid-19 by using a test approved by the CDC
- Individual, spouse, or dependent who was quarantined, furloughed, laid-off, of having reduced hours as a result of the Covid-19 outbreak.
- Individual or spouse who was unable to work due to a lack of childcare
- Individual, spouse, or household member who is a business owner that had to reduce hours or close their business due to Covid-19
- Experienced a reduction in pay or self-employment income due to Covid-19, had a job offer rescinded, or a job start date delayed
Just Because You Can, Doesn’t Mean you Should
The intent behind this law is a good one. Millions of people are struggling. There have been over 45 million first-time unemployment claims since March. That also doesn’t account for those who have had their hours cut, experienced furloughs, or have had job offers rescinded.
However, it may not be a good idea to take a distribution or a loan unless it is absolutely necessary. And if you do, it would be best to err on the smaller side and take out just as much as you may need without taking out more than you need. You can take out more than one distribution in the 2020 calendar year if you need more money later. But it’s tempting to spend the extra money if you take out more than is absolutely necessary.
If You Need the Money Should You Take Out a 401(k) Loan or a Distribution?
401(k) loans are inherently riskier than taking a distribution, especially under the new law. The new law allows you to take a distribution of up to $100,000 without being assessed an early withdrawal penalty if you are under age 59½. You still have to pay any taxes due, but those payments can be stretched over three years. Finally, you retain the option of repaying the distribution within three years and being able to file an amended tax return to claim the taxes you paid on the distribution.
On the other hand, a 401(k) loan requires you to immediately begin making payments, with interest, on the amount borrowed. If you default on your 401(k) loan, you would be required to claim the outstanding balance of the loan as a distribution in the year you default on the loan. You would also be required to pay taxes and the 10% early withdrawal penalty if you are under age 59½.
There are other risks to taking out a loan. If you lose your job, for example, you will be required to repay the loan before the due date for your tax return the following year. Otherwise, you would owe taxes and penalties on the outstanding balance.
Of these two options, taking a distribution is a lower-risk proposition. But only if you absolutely need it.
© 2022 Forbes Media LLC. All Rights Reserved
This Forbes article was legally licensed through AdvisorStream.