Americans who are struggling to pay the bills amid the novel coronavirus pandemic may receive some welcome relief from the recently passed $2 trillion stimulus package. But using the new provisions can also have long-term financial implications that must be carefully considered.
Before taking advantage of the CARES Act retirement plan provisions, in particular, consumers should consider the effects short-term moves will have on portfolios in the long term. In many cases, it may be wise to consult a financial professional.
Among other provisions, the historic legislation will:
- Allow for larger penalty-free early withdrawals from retirement accounts.
- Relax the rules for retirement plan loans.
- Suspend payments on existing retirement plan loans for 2020.
- Waive the requirement for 2020 retirement account distributions.
Such measures can be a critical lifeline for those who have experienced a drop in income and need money now, and for retirees who need time to let their retirement account balances potentially recover from the stock market slide. The package also includes a number of provisions for immediate payments, small business loans, and unemployment benefits for those left in immediate need by the crisis.
But it’s the retirement plan provisions that financial professionals suggest must be treated with a healthy dose of caution.
Penalty-free retirement plan withdrawals
For example, many could benefit from a temporary easing of the rules that govern retirement account loans and withdrawals – including employees and even small-business owners who have suffered an income loss as a result of the coronavirus pandemic.
Normally, anyone who withdraws money from their qualified retirement account, including 401(k), IRA, or 403(b) accounts, before age 59-1/2 is assessed a 10 percent early withdrawal penalty on that amount. The stimulus package will allow investors of any age who require a “coronavirus-related distribution” to take up to $100,000 from their retirement account in 2020 without incurring the penalty. They would still owe ordinary income tax on the amount withdrawn, which could be paid over three years, but that tax can be avoided if the withdrawn amount is replaced within three years.
“The big question is, will people pay that money back?” said John Iammarino, a financial professional with Securus Financial in San Diego, California, in an email interview.
If distributions are rolled back into your account using this option, you will have to file an amended tax return to claim a refund of any tax paid attributable to the rolled over amount, he noted.
Financial professionals urge retirement savers to tread with caution and to treat an early withdrawal as a last resort. Why? It can seriously compromise your long-term financial security and could increase the risk that you will outlive your savings in retirement. By selling in a depressed market, you are “locking in your losses,” said Iammarino.
If you were to take, say, a $30,000 distribution from a $100,000 account and did not repay it, you would lose the opportunity for compounded growth on that distribution, which adds up over time.
Consider that a pretax retirement account worth $100,000 would grow by $62,000 to $162,000 in 10 years assuming a conservative 5 percent annual return. By comparison, an account worth $70,000 growing at the same 5 percent rate per year would grow by $44,000 to $114,000 in 10 years.
Lost earnings make it harder to achieve financial security, a top concern among pre-retirees. A 2018 MassMutual study found that 28 percent of pre-retirees worry most about having enough retirement income to enjoy themselves, while 20 percent said their greatest concern was running out of money.1 Both ranked higher than “poor health,” which 10 percent of respondents said was their biggest fear.
Retirement plan loans
The new law also raises the limit on retirement account loans from a 401(k), 403(b), 401(a), or qualified government plan to $100,000 from $50,000, and 100 percent of the vested account balance. Financial professinoals generally prefer retirement account loans to a withdrawal of retirement funds. With a loan, you repay the loan with interest to yourself. The interest rate is typically far lower than you would pay to a bank or other lender. To qualify, the loan must be made by September 22, 2020, and the participant will not owe income tax on the amount borrowed from the 401(k) if it is repaid within five years, according to the IRS and Securities and Exchange Commission.
“Generally speaking, taking a loan is preferable to the 401(k) distribution,” said Iammarino. “You don’t have to pay taxes because it’s a loan and any interest you pay on the loan goes back into your retirement plan.”
Be aware, however, that if you fail to repay your loan on time, the amount borrowed will be treated and taxed as an early distribution. If you are younger than age 59-1/2, you would also be hit with a 10 percent penalty. And here again, you forfeit any investment gains you might otherwise have earned while the money is out of your account.
Another potential downside to consider when taking out a 401(k) loan is that you repay the loan with money that has already been taxed. And you’ll owe taxes again on your distributions when you take it out in retirement, so the money you borrowed and repaid is effectively taxed twice. People, including retirees, cannot borrow from their IRA. (Learn more: Retirement loans: Think carefully before you borrow)
Suspended loan payments for 2020
Under certain circumstances, some participants who have already taken out loans against their workplace retirement plans will also be permitted to suspend their loan payments that were scheduled to occur between the effective date of the Act and December 31, 2020. Those repayments may be suspended for one year.
In order to qualify for suspension, the participant must be a person who:
- Was diagnosed with COVID-19 by a test approved by the Centers for Disease Control and Prevention.
- Has a spouse or dependent who was diagnosed.
- Experiences adverse financial consequences as a result of being quarantined; was laid off, furloughed, or forced to work reduced hours as a result of the virus; is unable to work due to a lack of child care due to the virus; closed or reduced hours of a business owned or operated by the individual due to the virus, or experienced other factors as determined by the Secretary of the Treasury.
When payments resume, the loan must be reamortized to reflect the interest that accrued during the suspension period. All subsequent loan repayments will also be “backed up” a year so that participants will not be simultaneously paying the regularly scheduled payment and a payment that was postponed under the stimulus package.
Waived IRA distributions
The CARES Act waived required minimum distributions (RMDs) from retirement savings accounts for 2020, so those age 70-1/2 or older who can afford to skip their 2020 distribution don’t have to take money from their pretax retirement portfolios when the market is down. That gives their account balances time to recover. That applies to 401(k), IRA, SEP IRA, SIMPLE IRA, 403(b), and governmental 457(b) plans. It also applies to beneficiaries taking stretch distributions, said Iammarino.
If you will turn 70-1/2 in 2020 or later, note that you will not need to begin taking RMDs until after you reach age 72, the new age for RMDs imposed by the SECURE Act.
Normally, retirees pay a hefty 50 percent penalty tax on any amount of their annual RMD not withdrawn.
RMDs are based on account balances at the end of the prior year, so a 2020 distribution would have been based upon a much higher portfolio value as of December 31, 2019. Adding insult to injury, that might have pushed some retirees into a higher tax bracket.
“Waiving 2020 RMDs will help people out with the tax bill on their IRA,” said Iammarino. “It will save them from being forced to liquidate securities in a down market, locking in those losses and exposing them to sequence of returns risk,” which occurs when distributions in a depressed market compound their portfolio losses over time.
Some retirees, of course, need their RMDs to pay the bills and can’t afford to skip their distribution for 2020. But if they qualify for the government’s one-time stimulus payments and can afford to delay taking their RMD for a few extra months, it could give their portfolios time to recover, said Iammarino.
“If they qualify for the government recovery rebates, and they don’t need to take distributions, then they may want to stop distributions for now, while the market is down, to limit compounding those losses,” he said.
Another important point regarding the RMD waiver is that retirees can potentially take money out of their IRA to perform a Roth conversion without having to account for the RMD first. The Internal Revenue Service normally requires seniors to take their RMD first before they can perform a Roth conversion.
“No forced RMDs and no taxes on that money means more money for potential Roth conversions,” said Iammarino. Even better, you can perform a Roth conversion in a down market and, assuming the market rebounds, you will get the rebounding and subsequent growth tax free.”
The CARES Act waiver RMDs did present a problem for taxpayers who had already taken their 2020 RMD before the legislation was passed on March 27. Many wanted to put their distribution back into their account, but were unable to do so. On June 23, the IRS announced that anyone who already took an RMD in 2020 from an IRA can now roll those funds back into their IRA until August 31, 2020.
Roth IRAs are funded with after-tax dollars, so there’s no immediate tax benefit on contributions. But earnings can be withdrawn during retirement tax free, and RMDs do not apply to Roth IRAs, so the money can continue to grow tax-free throughout your lifetime. (Learn more: 8 FAQs on traditional vs. Roth IRAs)
Other measures for loans, unemployment
Beyond the $500 billion in loans available to support businesses, the stimulus package, known as the CARES Act, will provide a one-time payment of $1,200 for single Americans making up to $75,000, and $2,400 for married couples making up to $150,000. Parents would receive an additional $500 for each dependent child under age 17. The payment amounts begin to phase out above those income thresholds, and will not be available at all for individuals who earn more than $99,000 and couples who earn more than $198,000.
The new law also expands unemployment insurance for jobless workers, providing an extra $600 per week for four months, in addition to state unemployment benefits being provided. Self-employed workers and independent contractors, who fuel the so-called gig economy, will also be eligible for benefits.
The CARES Act stimulus package passed by Congress tries to provide unprecedented relief for American workers and businesses. Those struggling to make ends meet as the coronavirus outbreak unfolds should look to determine which relief initiatives they may be eligible to receive, and consult their financial professional for guidance as appropriate.
This article was originally published in April 2020. It has been updated.
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1 MassMutual, “Retirement Income Study,” June 2018.