The CARES Act includes options allowing your clients to tap into their retirement accounts if they need the funds to deal with financial hardships arising from the coronavirus pandemic. Here’s what your clients need to know about these options and about the implications of tapping their retirement accounts early:
The CARES Act offers two ways for retirement plan participants to access money from their retirement accounts.
Increased 401(k) loan limits: The CARES Act raises the amount that plan participants can borrow from their 401(k) plan account from the lessor of $50,000 or 50% of their plan balance to the lessor of $100,000 or 100% of their balance. These increased limits are supposed to be on account of some pandemic-related reason, but this is done via a self-certification process. This provision also includes liberal loan repayment terms for both new and in some cases already outstanding loan balances.
Retirement account distribution rules have been modified to allow individuals to withdraw up to $100,000 without incurring the normal 10% penalty. These distributions must be due to COVID-19 related issues such as the participant or a family member contracting the disease, or if the participant has suffered a financial consequence resulting from the pandemic such as reduced income. The taxes on these distributions can be spread out over three years and there are provisions to allow “recontributions” back into the account that would reduce the amount of the distribution and the taxes owed.
As a financial adviser you certainly know the potential consequences of taking retirement account distributions or increasing the amount of your client’s 401(k) indebtedness. In some cases your clients may be in dire straits financially due to job loss or other circumstances and need to either take a 401(k) loan or a distribution from an IRA or company retirement plan in order to make ends meet. However, for clients with other options you should discuss the ramifications of a 401(k) loan or retirement account distribution with them.
It should be noted that both the expanded 401(k) loan limits and the hardship withdrawal features in relation to an employer sponsored retirement plan like a 401(k) are not automatic. The plan sponsor must add these features to the plan in order for their participants to be eligible.
401(k) Loan Issues
While a 401(k) loan does not trigger a taxable event, it is not without potential costs.
An outstanding loan still leaves less money available in your client’s account for investment. They will be taking the loan out when the stock market is well off its highs and when their account value is reduced. This money will not be invested, and your client would miss out on any growth for this money should the stock market rebound.
There is also the issue of what happens if your client leaves their employer, either voluntarily or involuntarily, with an outstanding loan. Depending upon the terms of their employer’s plan this amount could be taxed and potentially subject to a 10% penalty if the loan is not repaid within a set time frame.
On the other hand, assuming that your client stays with the employer long enough to repay the loan through payroll deductions, this could mitigate some of the downside, especially if their situation allows them to resume regular contributions to their account.
The taxes due and the reduced balance available for your client’s retirement are the biggest downsides. An early withdrawal can make a huge dent in your client’s retirement nest egg. If they are in a position where a withdrawal is needed, this likely means they won’t be in a position to make contributions to their retirement plan going forward as well, compounding the damage to their retirement planning.
Fear might be driving some clients to look at either borrowing against their 401(k) or taking a retirement account distribution. They may be thinking they want to get some money out of their account to avoid further losses. While this is understandable, the better route would generally to work through their fears with them, adjusting their allocation to stocks if needed to keep them invested.
As previously mentioned, if your clients are in dire financial straits due to COVID-19 and they have no other avenue to get the cash they need to meet their obligations, then either a 401(k) loan or a retirement account distribution might be their best option. If they do go this route, a 401(k) loan might be the better option if available to them. You can then work with them through the process of repaying the loan and hopefully getting back to their normal contribution rates once their situation improves.
If they go the distribution route, it's important to advise about the ability to both spread the tax obligation over a three-year period and the option to recontribute some or all of the money back into the plan if they have the financial means to do so.
If your client is looking at either of these options and doesn’t have financial hardship but is merely looking for a source of funds for other purposes, you should generally discourage this due to the potential costs and the potential impact on their retirement savings.
While there are no absolutes and every client’s situation is different, it's important as your client’s financial adviser that you frankly and honestly discuss the pros and cons of these options in light of their situation so you and your client can make the best decisions to help them through this period of financial uncertainty.