Signed into law on March 27, 2020, Congress created the Coronavirus Aid, Relief and Economic Security (CARES) Act to provide financial relief to Americans suffering from the economic fallout of Covid-19.
Several of the more high-profile retirement provisions of the CARES Act have expired—including stimulus checks, supplemental weekly unemployment benefits and the suspension of federal student loan payments. But there are still a few important CARES Act benefits that you can take advantage of before the end of 2020.
Covid-19 Early Retirement Account Withdrawals
The CARES Act eliminates the 10% withdrawal penalty for qualified retirement account holders who have a valid Covid-19-related financial hardship. It allows them to withdraw up to $100,000 from their tax-deferred retirement accounts, or taxable earnings in a Roth account, in 2020.
Under normal circumstances, withdrawing funds from most tax-deferred retirement accounts—like a 401(k) or a traditional IRA—before age 59 ½ triggers a 10% penalty from the IRS in addition to the income tax you’d normally owe on the withdrawal. Earnings, but not contributions, withdrawn from a Roth account are hit with the penalty as well.
Valid Covid-19-related hardships include a positive coronavirus diagnosis for the account owner, their spouse or a dependent; a lay-off, furlough, reduction in hours, inability to work or lack of childcare because of Covid-19; a delayed or rescinded job offer because of Covid-19; or Covid-related closing or reduced hours for a business owned by the account holder or their spouse.
The CARES Act has also waived the 20% mandatory tax withholding requirement for early withdrawals from workplace tax-advantaged retirement accounts. This withholding is how the IRS normally ensures that plan participants pay the necessary taxes on their early withdrawals.
But just because you can avoid both the early-withdrawal penalty and the mandatory withholding does not make your early distribution free of taxes, however. Michele Cagan, a certified public accountant (CPA) based in Baltimore, warns plan participants to remember the tax bite. “The lowest tax bracket under current tax law is 10%, so you need to prepare to pay at least 10% of what you take out. So if you need to take a $50,000 withdrawal, expect to owe at least $5,000 in taxes.”
The CARES Act allows for some flexibility in paying those taxes. Cagan notes that “you have the option of paying your taxes in three even installments for the 2020, 2021, and 2022 tax years.”
Here’s how that might look. According to Vanguard, the median coronavirus-related withdrawal was $12,000. A hypothetical participant could either choose to add the entire $12,000 withdrawal to their 2020 income to pay taxes all at once, or increase their 2020, 2021 and 2022 income by $4,000 each year, spreading the tax burden over three years.
That said, if your income was significantly diminished in 2020 and you can afford to pay any applicable taxes this year, you might save money compared to future years.
The CARES Act also allows participants to redeposit the money within three years of the distribution, which is much longer than the usual 60 day allowance for redepositing early withdrawals. If you do choose to return the money, you will owe no taxes, although you may have to file an amended tax return to get back any taxes you paid on the early distribution prior to redepositing it.
The Pitfalls of Early Disbursements
While expanded access to retirement funds may provide an important financial lifeline, Cagan suggests participants try to exhaust other options first. “Even with all of these CARES Act breaks, taking early withdrawals could end up costing you thousands of dollars and putting you in an even worse financial position than you’re already in,” she says.
That’s because money taken out of your retirement investments can’t grow. “You lose the momentum of your investment which makes it harder for your account to recover,” Cagan says. “And though you may need money now, you’re taking it from your 75 or 80-year old self, and it will be that much harder to get needed money once you reach that age.”
These pitfalls may explain why only 4.5% of Vanguard plan participants decided to take a coronavirus-related distribution as of Oct. 30, 2020.
Coronavirus 401(k) Hardship Loans
In addition to penalty-free early withdrawals, the CARES Act also expanded hardship loans from employer-sponsored retirement accounts—such as 401(k), 403(B), and 457s—until Sept. 22, 2020.
Under the CARES Act, plan participants were allowed to borrow up to 100% of the vested balance or $100,000, whichever was less. This was double normal hardship loan limits—50% of the vested balance or $50,000, whichever is less.
The window for borrowing the expanded amount from a workplace retirement account has already closed, so anyone considering a hardship loan now will be limited to the 50% or $50,000 maximum—or a coronavirus hardship withdrawal of up to $100,000.
One hardship loan provision does remain in effect until December 31, 2020: If you took a hardship loan prior to the Covid-19 pandemic and have a repayment due between March 27 and Dec. 31, 2020, your repayment can be delayed for up to one year. That’s because the CARES Act allows retirement account borrowers (including new borrowers) to forgo repayment in 2020. Under normal circumstances, you must pay back your loan within five years and you are required to begin paying it back immediately.
According to Vanguard, only 1.0% of plan participants took advantage of the Coronavirus Hardship Retirement Account Loan options. This may be in part because participation in the loan program was optional, so not all workplaces allowed for participants to take loans. But the downsides of 401(k) loans may also have discouraged people.
The Pitfalls of a 401(k) Loan
According to Kevin Matthews II, creator of Building Bread, a financial education company, “People think a 401(k) loan has no drawbacks since you repay it. But taking money out of the market means you lose the compounding factor, and you won’t see the true opportunity cost until years later.”
Considering the major market rebound since May of this year, Matthews worries that participants who took 401(k) loans in the spring, when the market tanked, may have hurt their future account growth. “Borrowers won’t see the same bounce as those who remained invested,” Matthews says. The S&P 500, for example, has grown 64% from its March low as of mid December 2020.
Additionally, job stability is a concern for 401(k) loans. Though participants are no longer beholden to the old rule requiring repayment of such a loan within 60 days of terminating employment, you will still have to repay it when your federal tax return is due for that year, with extensions, or else you will have to treat the loan as a distribution and owe taxes on it.
For 2020, that means if you take a loan this year and lose your job, you will have to repay the loan in full by Oct. 15, 2021. For that reason, if your job is not secure, a 401(k) loan could be a risky proposition and wind up a large financial burden.
Should You Take Money from a Retirement Account?
While financial experts implore struggling Americans to find other places to look for extra money, like 0% APR credit cards or low-interest personal loans, Cagan concedes that “if you need to take it because there are no other choices, then take it.”
But don’t take the maximum simply because you can. Cagan recommends you take only what you need and not more. “But consider including the amount you will need to pay taxes so you’re not left scrambling come tax time. For instance, if you need $30,000, plan on withdrawing $34,000 and paying your tax bill with the excess.”
And to prevent such a dilemma in the future, Matthews offers some advice: “Everyone should have three different tax buckets for investing: a tax-deferred retirement account, a Roth retirement account and taxable investments. Then, if you’re strapped for cash, you can take money from the taxable investments without worrying about the implications on your tax-deferred retirement accounts,” he says. A Roth, with its penalty-free and already-taxed contributions, might then be your next line of defense.
The CARES Act and RMDs
Another important provision of the CARES Act was the suspension for 2020 of required minimum distributions (RMDs), or mandatory minimum withdrawals the IRS mandates for most retirement accounts. This was done to give retirement accounts a chance to bounce back from the market downturn in the first half of 2020.
Until Aug. 31, 2020, anyone who had already taken an RMD for 2020 and wished to return it could do so with no penalty. If you have not yet returned your RMD for 2020, though, the window has closed.
The IRS normally requires RMD withdrawals from retirement accounts belonging to individuals over age 70 ½ (for those born before July 1, 1949) or age 72 (for those born after July 1, 1949) as well as non-spousal heirs who inherited tax-deferred accounts. RMDs are calculated each year based upon the balance of the account on December 31 of the previous year.
Charitable Giving Under the CARES Act
In addition to decreasing your taxable income by avoiding RMDs this year, you may also be able to decrease income through charitable donations in 2020.
The CARES Act allows taxpayers who don’t itemize their deductions to take up to a $300 deduction for a cash contribution made to qualifying organizations in 2020. Under normal rules, you cannot deduct charitable giving unless you itemize your deductions. Further, if you do itemize your deductions, the CARES has temporarily suspended limits on charitable contributions for tax year 2020. Normally, you are limited to deductions of up to 60% of your income. This year, you can deduct 100% of your adjusted gross income.
“For the first time ever, you can make your tax liability zero. Give 100% of your AGI to charity, owe zero taxes,” says Cagan.
The Bottom Line
With 2020 rapidly drawing to a close, there are only a few weeks left for CARES Act provisions that can help you access needed funds or reduce your tax burden. However, though there is only a little time left, make sure you consider your financial options carefully before deciding to take advantage of any of these temporary rules.
Consider speaking to a financial advisor or tax professional for help with this decision. You don’t want to start 2021 with regrets because you made a hasty decision to beat the deadline.