Using Retirement Funds to Cover Covid Financial Losses

The Covid-19 pandemic has caused unprecedented financial fallout. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was intended to mitigate some of the resulting economic hardship.  A key provision of the CARES Act makes it easier for individuals to withdraw funds from retirement plans such as a 401(k) or Individual Retirement Account (IRA) in order to access needed capital. The changes temporarily eliminate the tax penalty on certain early withdrawals from retirement plans, relax the rules related to the payment of the resulting federal income tax, and make it easier to obtain loans from these types of accounts.

Generally, the amount withdrawn from an IRA or 401(k) is subject to federal income tax with the resulting amount due in the year of the distribution. Additionally, a distribution prior to age 59½ is subject to both federal income tax and a 10% additional tax penalty. There are a few exceptions to the 10 % penalty, such as using $ 10,000 in an IRA to purchase a first home or using funds in an IRA to pay medical insurance premium while unemployed, but the exceptions are very limited. The CARES Act allows eligible participants to take early distributions of up to $ 100,000 from retirement plans during 2020 without paying the 10% penalty and irrespective of age 

The CARES Act also affords greater flexibility with regard to the payment of the associated federal income tax. Although a participant may choose to have an eligible plan distribution taxed in 2020, they may also choose to include this amount in their income ratably over three years. The CARES Act further allows a recipient to return all or a portion of an otherwise taxable distribution to a retirement plan within three years in order to avoid any tax, effectively creating a plan loan. Typically, this period of redeposit is only 60 days. Moreover, the CARES Act suspends the mandatory 20% tax withholding requirement that normally applies to some early retirement plan distributions. 

In order to obtain the tax relief associated retirement plan distributions, the participant, their spouse or dependents must have been diagnosed with Covid-19. Alternatively, an individual is also eligible if they experienced adverse financial consequences stemming from Covid-19 such as: quarantine, work furlough, being laid off, having reduced work hours, loss of work due to lack of child care or the closure or reduction of hours of a business they owned or operated.

The CARES Act also enhanced loan provisions related to workplace retirement plans. Normally, owners of retirement accounts such as a 401(k), 403(b) or 457 plan are allowed to borrow the lesser of $ 50,000 or 50% of the vested plan balance. Generally, these types of loans are not taxable. Although an employer isn’t required to permit them, most do. These loans may be used for any purpose whatsoever. The CARES Act increases this loan limit to the lesser of 100% of the vested plan balance or $ 100,000 and further provides that the normal five year repayment period for these types of loans will not begin until 2021, giving borrowers extra time for repayment. However, the loan will accrue interest in 2020. Also, if a person loses their job after a loan is taken, they must repay it before the due date of their tax return for their final year of employment in order to avoid the entire unpaid balance being taxable.

Finally, it should be noted that the CARES Act eliminates the need to take a required minimum distribution from all retirement plans during 2020. Normally, individuals over the age of 70½ (for those born prior to July 1, 1949) or 72 (for those born after July 1, 1949) or holders of inherited retirement accounts no matter their age, must withdraw a minimum amount each year as calculated under the IRS rules and regulations. This requirement has been suspended for 2020.

Because of the tax law complexities associated with any retirement plan distributions or loans, it is strongly recommended that a person seek professional advice before taking one. 

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.

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