According to a recent CNBC article, millions of Americans have tapped their retirement plans with a CARES Act distribution. In fact, several have distributed the maximum allowable amount of $100,000. In the following, we’ll take a look at some of the numbers and help you decide if a CARES Act distribution is right for you.
What is the CARES Act?
The CARES Act, signed into law by the President on March 27, 2020, is a $2 trillion stimulus package aimed at helping Americans deal with the financial crisis due to the COVID-19 pandemic. It included much needed relief for millions of Americans via stimulus checks, expanded unemployment benefits and help for small business owners.
Some of the more important provisions are related to retirement plans. The Act allows for penalty-free withdrawals of 401(k) and IRA funds. It also improved 401(k) loan rules and waived required minimum distributions for the year.
The best provision, in my opinion, are the withdrawal rules. The CARES Act allows you to withdraw up to $100,000 penalty-free. Taxes will still be due on any amount withdrawn, however they may be paid over the next three years. This will lessen the tax blow when taking a large distribution. Further, if you re-contribute the funds to any retirement plan, you will owe no taxes. Essentially, you get a three-year loan of your retirement funds.
CARES Act Distributions – Facts and Figures
The above referenced article has some interesting data about people taking advantage of the CARES Act provisions:
- 17% of all distributions were “Coronavirus-related” according to ADP
- Over 700,000 distributions from Fidelity 401(k) and 4013(b) plans
- Median distribution of $4,800, with 18,000+ withdrawing the max
- 2% of Vanguard savers taking a distribution, with 4% of those taking the max
Certainly, there numbers show that there are thousands of Americans taking advantage of the lenient distribution rules. The worry is that some may not be aware of the consequences of withdrawing retirement funds. Experts agree that tapping a retirement plan early should only be used as a last resort. Also, a retirement plan distribution should only be taken for necessities. Of course, the COVID-10 pandemic may have led to people not having much of a choice.
Even during “normal” circumstances, funds should only be withdrawn when there is no other option. Retirement plans are set up in a way to grow tax-deferred, or tax-free if you have a Roth IRA or 401(k). The more money in the plan and the longer it’s there, the more power your funds have. If you withdraw half of your account balance, you lose the earning power of half your plan.
Be Aware of Distribution Consequences
As mentioned, retirement plans are tax advantaged. Funds in the plan are not taxed on an annual basis. If you have a traditional plan, taxes are deferred until you take distributions. However, there is an upfront tax break. You don’t pay taxes on any funds contributed. Alternatively, Roth plans are funded with after-tax money. There is no immediate tax break, but all qualified distributions are tax free.
Taxes Are Still Due
While the CARES Act allows for penalty-free use of your funds, taxes still need to be paid. To be clear, there is no 10% early distribution penalty for those under age 59 1/2. However, you will be taxed on anything withdrawn from your plan, even for coronavirus-related reasons. The good thing is that the taxes can be spread across three years (or paid in full next year). For example, if you withdrawn $15,000, you must report $5,000 in income over the next three years.
If you decide to re-contribute funds to the plan, you may file an amended return for any taxes paid in prior years. Lastly, when re-contributing a Coronavirus-related distribution, you may exceed the contribution limit of the plan.
The Power of Compounding
The power compounding is a quite simple concept. If you have $10,000 in a plan and earn 10% during the year, you will earn $1,000, giving you $11,000 in the plan. Then, that $11,000 earns 10% for an extra $1,100. At the end or year two, assuming no other contributions, your plan is worth $12,100. If you withdraw half of your plan funds, you will only earn $500 and $550 respectively. Now imagine what happens after ten or twenty years!
Whatever you take from the plan will lessen the earning power. That will have a ripple effect the longer the funds are not in your retirement plans. Therefore, you must be careful when taking CARES Act distributions. This is why it should only be used as a last resort and why you should take what you absolutely need.
One Last Thing About Taxes
As the CNBC article points out, how will you pay the taxes that will be due? Depending on your finances for this year, it may make sense to pay the taxes all at once. If you do not have a lot of income, because of a shuttered business or job loss, your income won’t be as much. Therefore, if you have minimal income in 2020, the tax hit won’t be as bad.
On the other hand, what if you’re still doing okay financial and at or near your usual income? A large increase in your income for the year might push you into a higher tax bracket. The same is true for those who reach normal income levels over the next two years, but decided to spread out the tax hit. Every situation is unique, so you must be aware of all possible consequences.
Should You Take a Distribution?
If you absolutely have to dip into your retirement savings, now is the year to do it. If you are under age 59 1/2 and have no other recourse, it’s a no-brainer. You might not have another opportunity to withdraw retirement funds without penalty. You must be smart about it. Have you explored all other avenues first? Remember, your IRA and 401(k) funds are for your retirement first and foremost. If available, a 401(k) loan option may be a better option for you. Afterall, you must pay it back and all interest is paid back to the plan.
Still unsure? It’s best to speak with a financial advisor to determine if a CARES Act distribution is right for you. IRA Financial can provide you with any answers to questions you may still have about the new rules. Contact us @ 800.472.0646 if you need further assistance!