As part of the CARES Act, plan sponsors can now offer coronavirus-related distributions (CRDs) as a means to offer participants greater access to their retirement funds and help deal with hardships associated with COVID-19. This option waives the 10% early withdrawal penalty for participants under age 59 1/2 for amounts up to $100,000 on 401(k)s or IRAs taken between January 1 and December 31st of 2020.
The Act does not mandate that employers offer this option to participants. It’s solely at the discretion of plan sponsors. Nor are plans that choose to adopt this new policy required to allow it up to the full $100,000 limit. They could, for example, restrict CRDs to $60,000 or $75,000. So, whether your client wants to offer this option at all — and up to what limit — is a conversation that you want to start having as soon as possible.
Note that CRDs are only available to “qualified individuals,” or someone who has been diagnosed with COVID-19, whose spouse or beneficiary is diagnosed or who experiences adverse financial consequences due to:
- Business closing due to COVID-19
- Job layoff
- Reduction in hours
- Inability to work because of lack of childcare due to COVID-19
- Other facts determined by the U.S. secretary of the treasury
The Act allows sponsors to rely on participants’ self-certification of CRD eligibility. However, it may be advisable to maintain some form of documentation for employee files.
Unlike a traditional hardship withdrawal, participants who elect to take this distribution will have up to three years to pay the taxes and replace the funds. In addition, they can repay that money to another qualified plan or an IRA that accepts rollover distributions, which offers a lot of flexibility for plan participants.
Loosening Loan Restrictions
The Act loosens some restrictions on participants’ access to money through plan loans. Previously, if your plan offered participant loans, typically the maximum a participant could borrow from the retirement plan was the lesser of $50,000 or 50% of the vested account balance. The CARES Act allows (but does not require) plans to increase that limit up to $100,000 or 100% of the vested account balance, whichever is lower. This too is only permissible for qualified individuals impacted by COVID-19.
To assist qualified participants impacted by COVID-19 with outstanding loans who might face difficulties meeting their repayment obligations and end up with a defaulted loan and an unanticipated taxable event, the Act lets plans allow for the suspension of repayments for a full year.
While the potential benefits for qualified participants facing coronavirus-related financial hardships is clear, so is the potential opportunity cost for missed future gains when a 401(k) early withdrawal is taken near the bottom of the market.
Another risky use of the program would be taking a CRD from a pre-tax retirement account, depositing that money into a Roth IRA and paying the resulting taxes over the course of three years. This action may raise a red flag with the IRS and potentially be treated as an excess contribution, making it subject to a 6% tax as long as the additional funds are in the account.
Advisors should make participants who elect to take a CRD aware of the potential tax consequences of these types of strategies and also discuss the impact of such a large withdrawal on their eventual retirement readiness. If participants look at these new CARES Act provisions as an opportunity to needlessly loot their already distressed accounts, the future impact on their retirement readiness could be disastrous.