The COVID-19 pandemic has been more than a health crisis—it’s been a financial crisis as well. Business closures, job loss, reduced hours, and limited financial relief led to many savings accounts taking a major hit. As a result, more than 2 million Americans took advantage of the waived penalty for early withdrawal from a 401(k) or other qualifying account set forth in the CARES Act of 2020. This benefit may have been a financial life raft for some, but the move to tap into retirement funds isn’t without short- and long-term impact.
401(k) Early Withdrawal in 2020
Dipping into a retirement savings plan such as a 401(k) before age 59 ½ typically is not without penalty. However, in response to the ongoing COVID-19 crisis, the CARES Act of 2020 made it possible for retirement savers younger than 59 ½ to withdraw, for Covid-related reasons, up to $100,000 from qualified accounts without paying the usual 10% early-withdrawal penalty. For Americans who took a withdrawal, the money is yours and you don’t need to figure out a repayment plan. However, the flip side to this move is that retirement funds you’d planned to live on in the future are now diminished.
Taxes Upon Withdrawal Still Apply
The CARES Act temporarily eliminated the 10% early-withdrawal penalty, but the legislation didn’t pardon the taxes due. While you don’t generally pay taxes on contributions to traditional 401(k)s and IRAs, you do need to report income and pay taxes upon withdrawal. This holds true even though the CARES Act canceled the 10% early-withdrawal penalty for a short time. The temporary rules allow for the distribution to be spread across three years, but you need to account for a least one-third of the taxes due on that amount on your 2020 tax return.
Paying it Back is Recommended
Though you’re not required to pay back this type of withdrawal, experts agree that it’s generally in the saver’s best interest. Doing so allows you to avoid the taxes and to replenish your retirement account. If you pay back the full distribution amount within the three years, you can amend your tax returns and get all the money back paid in taxes.
For those who took a plan loan, you generally have five years to pay it back. You’ll need to be diligent in sticking to the plan’s repayment schedule. A loan that isn’t paid back could be counted as a distribution, therefore taxes (and possibly a penalty) will apply.
Savers who took a coronavirus-related distribution have more leeway in developing repayment strategies that best serve their personal situations. Those who took a plan loan have less flexibility, but some repayment strategies could be advantageous, including:
- A mortgage refinance. Given the current low interest rates, refinancing might save a few hundred dollars a month. That savings could then be redirected to repay the 401(k) funds.
- A home equity line of credit. Take advantage of low interest rates, with the ability to pay back the line of credit over at least 10 years.
- Student loans. For savers with college-age children, don’t count out the possibility of relying on federal student loans to help fund college costs while using the freed-up out-of-pocket cash to help pay back funds taken from a 401(k), perhaps in a lump sum. A federal undergraduate loan interest rate of 2.75% through June 30, 2021 combined with conventional thinking that you can borrow to pay for college make a potentially attractive avenue. Just be aware to not overborrow and dig yourself deeper into debt.
Some people may need to apply more than one strategy to return the money to their 401(k), relying on different options that will get them through the next few years. Work with a financial advisor to help determine the best path forward to getting back on track.
As a small business employer, signifying your commitment to employees’ long-term financial goals by offering a tax-favored retirement benefit is a solid way to draw in and retain valuable employees. Retirement plans may seem complex and costly, but there are straightforward and easily-enacted options available that are more affordable than you might think.
The Savings Incentive Match Plan for Employees (SIMPLE) is a tax-favored retirement plan in which both employees and employers contribute to traditional IRAs. As long as an employer has no other retirement plan in place and doesn’t employ more than 100 workers, they are eligible to institute a SIMPLE IRA. Essential aspects of this plan include:
- Tax credits: Employers may be eligible for tax credits of $500 for the first three years of the SIMPLE IRA plan in order to counterbalance the costs of providing and managing the plan.
- Contributions: Employers are required to either make a matching contribution of one to three percent, depending on circumstances, to participating employees, or contribute two percent of each participating employee’s compensation.
- Tax deductions: In most cases employer contributions are tax deductible to the employer.
A 401(k) is a defined contribution plan in which an employer contributes a certain amount of employee’s pay (as chosen by the employee) to the plan. Essential aspects of this plan include:
- Contributions: Unlike SIMPLE IRAs, employers are not required to match contributions. An employee’s contributions to a traditional 401(k) are typically made on a pre-tax basis, with taxes on contributions and earnings deferred until they are distributed, usually upon retirement. 401(k) plans tend to be more appealing to employers than IRA-based plans because the maximum contributions are generally higher.
- Roth 401(k): This is an option in which an employee contributes to the plan on an after-tax basis. Distributions and earnings may be made tax-free in retirement after meeting certain conditions.
- Administrative costs: Because 401(k) plans are more complicated to maintain than SIMPLE IRAs, the administrative costs tend to be higher.
- Non-discrimination testing: 401(k) plans are subject to testing requirements designed to ensure that contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees (in 2020, this is someone who earned more than $130,000 the previous year). Those who fall into the “highly compensated” group can establish a Safe Harbor 401(k) plan in order to avoid nondiscrimination testing.
With a Simplified Employee Pension (SEP) plan, employees receive IRAs that are funded entirely through company contributions. Essential aspects of this plan include:
- Eligibility: SEP plans are more popular among smaller businesses with fewer employees, but employers of any size are eligible.
- Contributions: Employers who institute a SEP plan determine an amount to contribute each year, with a limit set by the IRS.
- Tax credits: Qualified employers may qualify for a tax credit of $500 per year for the first three years of the plan, and employer contributions are tax deductible on the employer’s tax return.
This Roth IRA plan invests in a U.S. Treasury retirement savings bond. Essential aspects of the plan include:
- Contributions: Employees contribute to their account on an after-tax basis through payroll deductions, a checking or savings account, or income tax refunds. Earnings and distributions are generally tax-free.
- Cost: Because employers don’t administer or make contributions to these accounts, the employer only needs to share the information about a myRA option with employees and set up payroll deductions when applicable.
Legislative passages in 2020, including the SECURE Act, which made changes to beneficiary distributions, and the CARES Act, which included a waiver of required minimum distributions (RMDs), helped to expand the playing field for savers. These two factors, combined with the lowest tax rates in recent history, make for a potentially optimal time for Roth conversions, and many Americans have jumped on board. Is it the right move for you?
The Difference Between Traditional and Roth IRAs
- Traditional IRA or 401(K): enjoy a tax deduction upon contribution but pay taxes upon withdrawal
- Roth: no tax-deduction upon contribution but enjoy tax-free growth and no additional taxes upon withdrawal
The decision comes down to whether to pay taxes now or later. If only a crystal ball existed in which future tax rates could be known.
What Is a Roth Conversion?
A Roth IRA conversion is when an investor transfers money directly from a traditional IRA or 401(k) to a post-tax account such as a Roth IRA. The move is considered a distribution, and thus is taxed in that year. Due to today’s historically low tax environment, Roth conversions are having their moment in the sun.
Advantages of Converting to a Roth IRA
An essential benefit of converting to a Roth IRA is the potential for lower taxes in the future. While it’s obviously not possible to predict future tax rates, you can likely estimate if you’ll be earning more money, and thus, land in a higher tax bracket. If such is the case, odds are typically in your favor to pay less taxes in the long run than you most likely would with the same amount of money in a traditional IRA. Additionally, contribution withdrawals are tax-free (withdrawals from earnings are not tax-free). However, avoid using a Roth IRA like a bank account as any withdrawn funds today, however small, can impact your future savings.
Transferring to a Roth also means you won’t be required to take minimum distributions (RMDs) once you reach age 72. If you’re able to keep the funds in the account, you can watch it grow tax-free, and you would have the option to pass the money to your heirs.
Disadvantages of Converting to a Roth IRA
The biggest deterrent for a Roth IRA is the potentially immense tax bill. If, for example, an investor has $100,000 of pre-tax dollars in a traditional IRA and falls within the 24% tax bracket, the investor would owe $24,000 in taxes, due upon their next quarterly tax bill. Additionally, if the investor is under age 59 ½ and uses the IRA funds to pay the tax bill, they’ll also pay a 10% early withdrawal penalty on that distribution. In other words, be sure you have the liquid assets to cover the tax bill as a result of the conversion.
To Convert or Not to Convert?
If your taxes rise due to government increases, or you begin earning more money and land in a higher tax bracket, a Roth IRA conversion could save you substantial money in taxes in the long run. However, there’s a potential for a hefty tax bill that can be complicated to calculate, especially if you have other IRAs funded with pre-tax dollars, so if you think it might be a good move, it’s best to consult with a tax advisor on your specific circumstances.
Customarily, retirement savings plans such as 401(k)s are tough to withdraw from before age 59.5 without accruing penalties and tax withholdings, but the CARES Act, which was passed by Congress in response to the economic hit caused by the Covid-19 pandemic, temporarily eliminated such penalties. Now that you can more easily access assets that have been set aside for future use, should you?
Amended Penalties for Early Withdrawal
Recognizing that many Americans who live paycheck to paycheck would need access to funds in the face of lost income as a result of government shutdowns, Congress passed the CARES Act, which temporarily eliminates the 10% early-withdrawal penalty and the 20% federal tax withholding on early 401(k) withdrawals. Taxes on any withdrawn funds will still be applicable because the original contributions were pre-tax, but whereas those taxes are typically due within the same year as the withdrawal, the CARES Act permits the amount due to be stretched over a period of three years.
Be Aware of Potential Penalties
It may seem as though the vault has been unlocked, but before you decide to take advantage of the easily accessible funds, you should consider the potential ramifications of such a move. If the amount withdrawn isn’t returned within the three-year window (either in one lump sum or in multiple payments over three years), you will be responsible for paying income tax on the withdrawal. This could be a significant amount depending on the size of the withdrawal. It’s also worth remembering that for the amount of time the funds are out of your retirement savings, they discontinue making returns on your investment, which could result in potentially long-term consequences, including compound tax deferred growth benefits.
Remember the End Goal
If you are struggling in today’s economic downturn, the laxed rules and penalties to access retirement funds is tempting, but it’s important to keep the end goal in sight, which is retirement. The long-term impact to your savings, even when it’s paid back over time, may not be worth it. Unless you’re really struggling to make ends meet, the best move is to leave the money in your 401(k). Cashing out now, when the market reflects depressed values, means that you’d be selling low, which isn’t a recommended strategy.
Beginning next year, for the first time in 39 years, Social Security is projected to dispense more money than it takes in, which means that the money being collected by the program will soon not be enough to cover the benefits being paid out. Does this mean that Social Security is going bankrupt?
How the Program Came to Be and How it Works
In 1935, after decades of American workers advocated for a social insurance program that could help support retired workers, President Franklin D. Roosevelt signed the Social Security Act into law. Social Security taxes were first collected in 1937 with payments to retired workers beginning in 1940.
A dedicated tax on earnings funds the Social Security program, and the collected money is disbursed as retirement benefits for retirees in the form of a monthly check. How much money a retired worker gets from the program is measured in “work credits”, which are based on total income earned during their career. The program also supplies survivor benefits in many cases to widowed spouses.
What Went Wrong?
Social Security was signed into law over 80 years ago, and there have been significant shifts in demographics since then. The baby-boom generation is retiring, tipping the scale on the worker-to-beneficiary ratio, but other contributing factors include:
- growing income inequality
- sizable decline in birth rates
- legal immigration, which has been cut in half over the last two decades
- Longer life expectancy as a result of modern medicine, which means people are collecting checks for more years than earlier generations
Is Bankruptcy in the Future for Social Security?
Rumors of the program’s impending bankruptcy have been circulating for years, and some people believe that Social Security funds are going to run out, leaving the workers who are paying into the system now without benefits. This is unlikely to be the case, but lawmakers rightfully continue to discuss proposals to Social Security legislation that would protect the program in coming years. While GOP lawmakers have expressed a desire to raise the minimum age at which you can begin to receive payments, Democrat lawmakers have proposed increasing the payroll tax that pays for Social Security. Neither plan is perfect. The GOP proposal would take years before any savings are realized, and the democrats’ plan to tax the rich would only put the program on borrowed time until it’s back in the same position. A bipartisan plan is needed for the future of Social Security, but how long it will take lawmakers to get there remains to be seen.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act passed by Congress at the end of March provides direct economic assistance to Americans during the COVID-19 pandemic. In the bill, certain provisions allow people to withdraw from their retirement accounts, including their 401(k)s and IRAs, without the usual early withdrawal penalty. Individuals must have been directly affected by coronavirus – through personal, spousal, or dependent diagnosis or furloughed, laid off, or reduced hours from their job to be eligible for the fee-free withdrawals.
While pulling from retirement funds seems like a simple and fast fix, it may not be the best option based on an individual’s circumstances. Those who stand to suffer the most amid the pandemic are those who are nearing retirement and those already in retirement. The unexpected ups and downs, current unemployment, and new potential health costs in this unprecedented time leave many Americans wondering how they’ll be able to retire comfortably in the current economic climate.
Consider these Options to Counteract the Effects of COVID-19 on Retirement Funds
Keep Current Costs Low
Take a look at current expenses and determine if anything can be eliminated or reduced. Any unused subscriptions? Are you paying for the right amount of insurance? Consider shopping around for lower rates. Can you negotiate any current bills – cell phone, credit cards, internet, anything with an interest rate, even your cable? Hold off on any major home or equipment upgrades and work with what you already have before adding on another expense.
Use Your Home
Assess your risks for taking out a second mortgage or a reverse mortgage. If your mortgage is already paid off, look into home equity loan options. A cash-out refinance may also be available if you’re still paying the mortgage. Over one-third of Americans have their wealth tied up in their homes, so it may be worth it to see if downsizing your home is an option. If so, it might be possible to pay for your smaller home in cash and use the remaining proceeds from the sale of your old for any outstanding debts or liabilities as you near retirement. The location of your home should also be considered – the cost of living can vary significantly from state to state, so moving to a new state or country may bring you more bang for your buck.
Plan for the Long-Term
Health care and long-term care can be an extreme cost for senior citizens. Assisted living and nursing home facilities usually top $60k+ for just one year. Long-term care insurance is costly but can help prepare you and your loved ones to pay the necessary costs. With Americans living longer each year, it’s worth it to plan on trying to stretch your retirement savings to last until age 90. Calculate how much you (and/or a spouse) would need with the assumption you’ll live to be 90. It’s also worth looking at final expense insurance, which could help cover final expenses at the end of your life. Planning for the event in advance can take the financial stress off family members left behind, whether it’s through final expense insurance or setting up a savings account with the express purpose of paying for any final expenses.
While we’re in a global pandemic, everything isn’t all doom and gloom. COVID-19 has hit the country, and our bank accounts hard, but people will bounce back after this economic crisis – much like investors after other recessions in our nation’s history.