The CARES Act provisions offer expanded access to retirement accounts for individuals. For clients who may be considering taking advantage of either of these provisions, it’s important to help them look at the potential impact on their retirement.
Retirement Plan Distributions
The CARES Act allows individuals to withdraw up to $100,000 from a retirement plan such as their 401(k) or an IRA without a penalty if they are under age 59 ½. In order to take advantage of this, your client will need to document how they have been impacted by COVID-19. This could be via a diagnosis of COVID-19 for your client, their spouse or a family member. It could also include a financial hardship, such as reduced earnings due to the impact of the pandemic.
The waiver of 10 percent penalty is retroactive to the beginning of 2020. The distributions will still be taxable, but the tax can be spread over the next three tax years, and your client will be allowed to “recontribute” the money back into their account to avoid some or all of the tax.
The CARES Act has also allowed 401(k) plan sponsors to raise the limit on outstanding loans from a maximum of $50,000 or 50 percent of the participant’s balance to $100,000 or 100 percent of the participant’s balance. Repayment rules have been liberalized, including those on loans currently outstanding.
Note both the plan distributions from employer-sponsored plans, as well as the 401(k) loan provisions need to be adopted by plan sponsors.
Impact on Your Client’s Retirement
Certainly, if a client is in dire financial straits and needs a cash infusion, one or both of these options might prove to be a good solution. But if this isn’t the case, or if they have other financial resources they can tap to tide them over, it’s important to discuss the potential adverse ramifications on their retirement associated with tapping their retirement accounts.
For example, with either a loan or a distribution, the money taken from the account is out of the market either permanently or at least for a period of time with a loan, assuming it is repaid. As Jim Blankenship, CFP, EA of Blankenship Financial Planning notes, this money loses the benefit of tax-deferred growth as your clients strive to accumulate enough for their retirement needs.
The potential tax hit can also be significant. For clients who may not be in a position to recontribute some or all of the money from a distribution, the taxes can cause another financial hardship for them. In the case of a loan, should your client leave their company, either voluntarily or otherwise, the loan could become a taxable distribution if not repaid, depending upon the plan’s rules.
Even for clients who can repay the loan or re-contribute to the account in the case of a distribution, these payments might inhibit their ability to fully contribute new money to their retirement accounts. This could put them in the position of coming up short when they do decide to retire, forcing them to make some hard decisions about the timing of their retirement, their lifestyle in retirement and a host of other issues.
It’s important to discuss the potential ramifications of tapping retirement accounts early with any clients who express interest in these two options available under the CARES Act.