Unprecedented times do not always call for unprecedented action. The current uncertainty in our world is suffocating. Uncertainty of health, uncertainty of normalcy, uncertainty of the economy. All of these changes around us can make it feel like we must make drastic changes ourselves. We can’t just do nothing at a time like this, can we? It feels logical that in extreme circumstances, extreme action must be taken. However, that “feeling” is precisely what can turn a bad situation worse.
On March 27th, 2020 President Trump signed the CARES Act which is set to inject over $2 trillion dollars into the economy. This is done in multiple forms, the headliners of which are the “Economic Impact Payments” to Americans of $1,200 per qualifying adult and $500 per qualifying child and the Paycheck Protection Program loans through the Small Business Administration that can be fully forgiven by the federal government. The CARES Act also included numerous other changes to tax rules around payment of payroll taxes, treatment of net operating losses, expansion of unemployment benefits, etc. There were also two significant changes to retirement accounts that bear discussion; allowing “coronavirus-related distributions” and waiver of required minimum distributions (RMDs) for 2020 (next week’s article).
Retirement accounts such as 401(k)s, 403(b)s, and individual retirement accounts (IRAs) exist to incentivize Americans to save for their own retirement by allowing either a tax deduction upon contribution or, in the case of ROTH accounts, no tax benefit up front but tax-free withdrawal. These incentives come with stipulations. If a withdrawal is taken from a qualified retirement account too early without a “valid excuse” the pre-tax portion of the distribution is subject to income tax and a 10% early withdrawal penalty. There are already several “valid excuses” for premature withdrawals and now we can add one more to the list for Coronavirus relief.
Retirement plan holders are now allowed to take up to $100,000 of early distributions in 2020 without penalty if they meet any of the following criteria:
- An individual, spouse, or dependent is diagnosed with COVID-19;
- An individual who experiences adverse financial consequences as a result of being quarantined, furloughed, laid off, or having work hours reduced;
- Being unable to work due to lack of child-care;
- Closure or reduced hours of a business owned by the individual; or
- Other factors determined by the Secretary of the Treasury.
Tax Treatment of Coronavirus-Related Distributions
The CARES Act provides a waiver from the 10% early withdrawal penalty and introduces new withdrawal exception rules to soften the blow of the tax bill that would normally come with such a distribution from a pre-tax account. By default, any Coronavirus Related Distributions will be included in income evenly over three years, 2020, 2021, and 2022. So, a $100,000 distribution from a 401(k) in 2020 only triggers recognition of $33,333 as taxable income in 2020. The taxpayer will include $33,333 as taxable income in 2021 and 2022 as well. The taxpayer does have the ability to elect to have the entire distribution included in income for 2020 which might result in a lower overall tax bill if 2020 income is much lower than is projected for 2021 or 2022.
In addition to spreading the income tax recognition, the account holder is also given the ability to repay the distribution at any point within three years of the date of the distribution. If the distribution is repaid, none of the distribution is taxable.
Last, a Coronavirus-Related Distribution from an employer-sponsored retirement plan such as a 401(k) or 403(b) is not subject to the normal mandatory 20% withholding for federal income taxes. This enables individuals to receive the full amount of the distribution, providing current liquidity, understanding the tax on that distribution will come due on the filing of the next (or next three) tax returns.
Do these early retirement account distribution rule changes mean that individuals should be looking at their retirement accounts for current liquidity? Everyone will be impacted by this unprecedented crisis differently, and some will most definitely need to take early retirement distributions, but it is worth stepping back before doing so. I love the context the charts below provide. This chart is from Nick Maggiulli on March 23rd in his article on investing during a crisis. Keep in mind, if you have bought the S&P 500 index anytime since mid-2017 (aside from the last week of December 2018) you bought at higher prices than today. To the extent you are able, stay calm and stay invested.
These are incredibly difficult times and the ability to tap into retirement accounts with reduced tax drag will be a benefit to many who do not have any other source of funds. Personal finance is just that, personal. Think long and hard and talk to your trusted advisors before liquidating retirement investments. For many these are the times to buy and hold, not sell and distribute. In fact, the other retirement account rule change in the CARES Act allows investors to do just that by waiving required minimum distributions for 2020. Unprecedented times do not always call for unprecedented action. Stay the course to the extent you have the capacity to do so.