Incorporated into law on March 27, 2020, Congress created the Coronavirus Aid, Aid, and Economic Security Act (CARES) to provide financial aid to Americans suffering the economic fallout from Covid-19.
Some of the more well-known CARES law pension provisions have expired – including stimulus checks, additional weekly unemployment benefits, and the suspension of federal student loan payments. However, there are still a few key benefits of the CARES Act that you can take advantage of before the end of 2020.
Withdrawals from the Covid-19 early retirement account
The CARES Act removes the 10% withdrawal penalty for qualified retirement account holders who have a valid financial hardship related to Covid-19. This allows them to withdraw up to $ 100,000 from their tax deferred retirement accounts or taxable income in a Roth account in 2020.
Under normal circumstances, withdrawing funds from most tax deferred retirement accounts – such as a 401 (k) or a traditional IRA – before age 59 will result in a 10% penalty from the IRS in addition to the income tax that you would normally pay on the account owe withdrawal. Income, but not contributions, that are debited from a Roth account will also be charged with the penalty.
Valid difficulties associated with Covid-19 include a positive coronavirus diagnosis for the Account Owner, their spouse, or a loved one. Dismissal, vacation, reduced working hours, incapacity for work or lack of childcare due to Covid-19; a delayed or withdrawn job offer due to Covid-19; or Covid-related closure or reduced hours for a business owned by the account holder or their spouse.
The CARES Act has also waived the compulsory withholding tax of 20% for early withdrawals from tax-privileged retirement accounts in the workplace. With this withholding tax, the IRS usually ensures that plan participants pay the required taxes on their early withdrawals.
However, just because you can avoid both the early withdrawal fine and the mandatory withholding tax, your early distribution is not tax-free. Michele Cagan, a Baltimore-based public accountant (CPA), 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 your earnings. So if you need to withdraw $ 50,000, expect taxes of at least $ 5,000. “
The CARES Act allows for some flexibility in paying these taxes. Cagan notes that “You have the option to pay your taxes for the 2020, 2021 and 2022 tax years in three straight installments.”
It could look like this. The median coronavirus-related withdrawal was $ 12,000, according to Vanguard. A hypothetical participant could either add the entire $ 12,000 payout to their 2020 income to pay taxes all at once, or increase their 2020, 2021, and 2022 income by $ 4,000 per year, spreading the tax burden over three years.
If your income has decreased significantly in 2020 and you can afford to pay all applicable taxes that year, you may be able to save money compared to years to come.
CARES law also allows participants to deposit the money back within three years of distribution, which is much longer than the usual 60-day early withdrawal repayment allowance. If you choose to have the money returned, you won’t have to pay any taxes, although you may need to file an amended tax return to get back any taxes you paid on the early distribution before you deposit again.
The pitfalls of early withdrawals
While expanded access to retirement funds can be an important financial lifeline, Cagan suggests that participants try other options first. “Even with all of these breaches of CARES law, early withdrawals could cost you thousands of dollars and place you in an even worse financial position than you already are,” she says.
That’s because the money from your retirement investments cannot grow. “You lose the momentum on your investment, making it harder for your account to recover,” says Cagan. “And although you may need money now, take it from your 75- or 80-year-old self and it will be much harder to get the money you need once you reach that age.”
These pitfalls may explain why only 4.5% of Vanguard plan participants opted for coronavirus-related distribution as of October 30, 2020.
Coronavirus 401 (k) hardship loan
In addition to penalty-free early withdrawals, the CARES Act expanded hardship loans from employer-sponsored retirement accounts such as 401 (k), 403 (B) and 457s through September 22, 2020.
Under CARES law, plan participants were allowed to borrow up to 100% of the vested balance or $ 100,000, whichever was lower. This was twice the normal hardship credit limit – 50% of your vested balance or $ 50,000, whichever is lower.
The window for borrowing the extended amount from a company pension account is already closed, so anyone considering a hardship loan now is limited to a maximum of 50% or $ 50,000 – or coronavirus hardship withdrawal of up to $ 100,000.
A hardship loan provision remains in force until December 31, 2020: If you took out a hardship loan before the Covid 19 pandemic and a repayment is due between March 27 and December 31, 2020, your repayment may be delayed Year. This is because the CARES Act allows retirement account borrowers (including new borrowers) to forego repayment in 2020. Under normal circumstances, you will have to repay your loan within five years and start repaying immediately.
According to Vanguard, only 1.0% of plan participants used the loan options for the Coronavirus Hardship Retirement Account. Part of this may be due to the fact that participation in the loan program was voluntary, so not all jobs allowed participants to take out loans. But the disadvantages of 401 (k) loans may have discouraged people as well.
The pitfalls of a 401 (k) loan
Kevin Matthews II, founder of Building Bread, a financial education company, explains, “People believe that there has been no downside to a 401 (k) loan since you paid it off. However, if you take money out of the market, you lose compound interest and won’t see the real opportunity cost until years later. “
Given the large rebound in the market since May this year, Matthews fears that participants who borrowed 401 (k) loans in the spring as the market rebounded could have hurt their future account growth. “Borrowers will not see the same recovery as those who stayed invested,” says Matthews. The S&P 500 grew by 64% compared to its March low in mid-December 2020.
In addition, job stability is an issue for 401 (k) loans. While attendees are no longer bound by the old rule of requiring repayment of such a loan within 60 days of termination of employment, if your federal tax return is due for that year with renewals, or you need to handle it, you will still need to repay it You take the loan as a distribution and you owe taxes on it.
For 2020, this means that if you take out a loan this year and lose your job, you will have to repay the loan in full by October 15, 2021. If your job is unsafe, a 401 (k) loan could be a risky endeavor and place a huge financial burden.
Should you withdraw money from a retirement account?
While financial experts urge Americans to find other places to look for extra cash, like 0% APR credit cards or low-interest personal loans, Cagan admits, “If you need it because there are no other options, go for it.” it. ”
But don’t take the maximum just because you can. Cagan recommends taking only what you need and nothing more. “But remember to include the amount you need to pay taxes so you don’t run into tax time. For example, if you need $ 30,000, plan to withdraw $ 34,000 and pay your tax bill with the deductible. “
To avoid such a dilemma in the future, Matthews offers some advice: “Everyone should have three different tax buckets on investments: a deferred tax account, a Roth pension account, and taxable investments. When you have money, you can withdraw money from taxable investments without worrying about the impact on your tax-deferred retirement accounts, ”he says. A Roth, with his unpunished and already taxed contributions, could then be your next line of defense.
The CARES Act and RMDs
Another important provision of the CARES Act was the suspension of the Minimum Payouts Required (RMDs) for 2020, or the mandatory minimum withdrawals that the IRS mandates mandate for most retirement accounts. This was done to give retirement accounts a chance to recover from the market downturn in the first half of 2020.
Until August 31, 2020, anyone who had already taken an RMD for 2020 and wanted to return it could do so without penalty. If you have not yet returned your 2020 RMD, the window has closed.
The IRS typically requires RMD withdrawals from retirement accounts from anyone over 70 ½ (for those born before July 1, 1949) or 72 years (for those born after July 1, 1949), and from illegitimate heirs who have inherited taxes. deferred accounts. RMDs are calculated each year based on the balance on December 31 of the previous year.
Charitable donations according to the CARES law
In addition to lowering your taxable income by avoiding RMDs this year, you may also be able to lower your income by donating to charity in 2020.
The CARES Act allows taxpayers who do not list their deductions to receive up to $ 300 deduction for a cash contribution to qualified organizations in 2020. Under normal rules, you cannot deduct donations to charity unless you list your deductions. When listing your deductions, CARES has temporarily suspended the charity donation limit for the 2020 tax year. Usually 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, you can zero your tax liability. Give 100% of your AGI to charity and don’t owe any taxes, ”says Cagan.
The bottom line
With 2020 drawing to a close quickly, there are only a few weeks left for the provisions of the CARES Act that can help you access the funds you need or reduce your tax burden. While your time is running out, it is a good idea to carefully consider your financial resources before deciding whether to avail yourself of any of these temporary rules.
Consult a financial advisor or tax advisor for help with this decision. You don’t want to start 2021 with regret because you made a hasty decision to miss the deadline.