The CARES Act includes provisions that make it easier for people to tap or borrow from their retirement money for coronavirus-related reasons. However, it’s up to employers to decide whether to implement the changes in their company’s 401(k) plans.
Here’s everything you need to know about these changes, and the pros and cons of allowing plan participants to take advantage of each.
Expanded retirement account distributions
Account holders under age 59½ can withdraw up to $100,000 from their 401(k) or IRA during 2020 without paying a 10% early withdrawal penalty.
The only catch is they need to meet one of the following coronavirus-related requirements:
- The account owner was diagnosed with COVID-19 by a CDC-approved test,
- The account owner’s spouse or dependent has been diagnosed with COVID-19 by a CDC-approved test, or
- The account owner experiences adverse financial consequences as a result of:
- Being quarantined, furloughed, laid off, or having work hours reduced because of the virus
- Being unable to work due to lack of childcare because of the virus
- Closing or reducing business hours due to the virus.
The CARES Act also waived the 20% mandatory federal income tax withholding from coronavirus-related retirement distributions (CRD).
Before taking a 401(k) withdrawal, employees need to be aware that the distribution is taxable. Those who take a CRD in 2020 must report the withdrawal when they file their federal income tax return in 2021.
However, for CRDs, participants have three years to either pay the taxes due on the distribution or replace the money and not owe taxes on it.
Pros and cons of coronavirus-related distributions (CRDs)
|Distribution doesn’t have to be repaid||The distribution is taxable income|
|Can avoid 10% early withdrawal penalty||Diminished retirement savings|
|Can spread out the taxes due over three years|
Increased 401(k) loans
Employees who don’t want to simply withdraw funds from their 401(k) account may be able to access the funds with a loan.
Currently, the limit for loans from a 401(k) plan is 50% of the participant’s vested balance, or $50,000, whichever is less. The CARES Act allows employers to increase the maximum loan amount to 100% of the participant’s vested account balance or $100,000, whichever is less. The increased loan amount is only available for a limited time, as the loan must be taken before September 23, 2020.
If the employer chooses to add these provisions, participants must first certify that they meet coronavirus eligibility guidelines, which are the same as for CRDs.
Employers can also choose to offer a one-year suspension on loan repayments due between March 27 and December 31, 2020. Interest continues to accrue on the loan during that time, so future loan payments will have to be adjusted to reflect the increased interest due.
Employees need to be aware that while 401(k) loans can usually be paid back over five years, the balance will be due much sooner if they leave their job. Employees who leave their job with an outstanding 401(k) loan have until the due date for filing their tax return for that year, including extensions, to repay the loan or roll it over into another retirement account.
For example, say Jack takes a $5,000 loan from his 401(k) in July of 2020 and does not make any payments. In October of the same year, Jack receives a job offer from another company and gives notice to his current employer. Jack would have until April 15, 2021 (or October 15, 2021, if he extended his tax return), to repay the $5,000 loan balance in full. If Jack can’t repay the loan by that deadline, the loan will end up counting as a distribution with taxes due.
Pros and cons of 401(k) loans
|Interest paid on the loan is deposited into the employee’s own retirement account||If the employee leaves their job, they have a limited window to repay the loan, or it will be treated as a distribution|
|Loans aren’t taxable income as long as they are repaid||Most plans do not allow employees to make retirement plan contributions while they have a loan outstanding|
These are optional provisions
While the CARES Act made these provisions available, it’s up to employers to decide whether to implement them in their plans. That requires employers to weigh the short-term and long-term interests of their employees. It’s a good idea to encourage employees to exhaust other available options before touching their retirement savings. Draining retirement savings now can leave them less secure in retirement.
Perhaps that’s why, according to an April 2020 survey by the Plan Sponsor Council of America, less than half of employers with smaller plans (those with fewer than 200 participants) have decided to implement the new CARES Act provision.
If you do choose to adopt these provisions, the CARES Act allows you to begin allowing withdrawals and loans immediately. You have more time to formally amend your plan to reflect the new rules. The Act gives employers until the end of the plan year beginning on or after January 1, 2022, to adopt the amendment.
Some plan recordkeepers have already required employers to opt out if they didn’t want to provide these updates. If you haven’t already, it’s a good idea to discuss the changes with your investment advisor or attorney. Then reach out to your plan administrator for help with amending your plan and issuing the proper notices to plan participants.