With shuttered businesses, soaring unemployment and careening markets, this year has not been conducive to long-term retirement saving mindset. And what’s the natural go-to for clients when times get precarious or downright desperate? Cash, which can be counted on to pay the mortgage and put food on the table. It can take precedence over saving for a retirement that is — or can seem — decades away.
This is exactly the kind of dilemma where financial advisors can prove their worth to clients, helping them avoid costly mistakes and possibly even reaping benefits when they prematurely tap into their retirement funds.
First, however, some tough talk is called for. Clients need to know that, however necessary, early withdrawals can be an expensive proposition. Such funds are generally taxable and may also be subject to a 10% early distribution penalty if no exceptions apply. Such funds may also take years to replace.
Also let them know that some retirement accounts can provide significant hedges against tough times. If a client is in debt or facing bankruptcy, for example, 401(k)s and IRAs are generally protected in bankruptcy under federal law but anything withdrawn becomes immediately exposed. They lose that protective shield and are exposed to creditors.
But assuming no non-retirement funds are available, sometimes a client must access a pile of cash even if it is marked “IRA.” Here are some safety precautions advisors can share with clients so they don’t lose even more by making costly withdrawal mistakes.
‘60-Day IRA loan’
There is really no such thing. Company plans can allow loans but borrowing from an IRA is a prohibited transaction.
In common usage, however, a 60-day IRA loan is understood as workers withdrawing their IRA funds, using them for anything they wish and then returning them (rolling them over) within 60 days to the same, or any other, IRA or plan they wish.
But here’s the problem: Given today’s fraught economic circumstances, a client desperate enough to make such a withdrawal may not have the funds to complete the rollover within the allotted 60 days — even where the IRS has extended some of these deadlines. If the funds cannot be put back in time, then the pretax funds will be taxable, plus a 10% penalty may apply. That bill won’t come due until next year, but then more funds might be needed, leading to a downward spiral, further eroding the retirement account.
And even if the client’s financial situation improves and funds are available for rollover, the funds might not be eligible to be rolled over if the IRA once-per-year rollover rule is violated. If any IRA-to-IRA or Roth IRA-to-Roth IRA rollover (60-day, indirect rollover) was done within the last 365 days, then the funds cannot be rolled over and will be taxable and subject to a possible penalty.
However, the once-per-year rule does not apply to rollovers from IRAs to company plans (or vice-versa) or to Roth conversions so, the rule will not be violated if the client happens to have a 401(k) that accepts rollovers, again assuming the rollover is completed within the 60 days.
Another benefit of the Roth conversion in this situation: If the client is in dire straits financially, the tax on the Roth conversion will be minimal, so that could be a good tax move.
Roth IRA withdrawals: Hidden upside?
Roth IRAs should be the last on the list of funds withdrawn because these funds have already been taxed and are growing tax-free. But if there’s no choice, it could be a place to find money without a tax cost — providing the Roth funds are truly available tax-free.
In general, once a Roth IRA owner reaches age 59 ½ and has held any Roth IRA for 5 years, any Roth withdrawals are “qualified distributions” and can be withdrawn tax free. In addition, regardless of age or holding period, Roth IRA contributions (note: not conversions) can be withdrawn at any time and for any reason, tax and penalty free.
Fortunately, under the tax rules for Roth IRA distributions, the first dollars withdrawn from a Roth IRA are deemed to come from Roth IRA contributions. Once the contributions are withdrawn, the next dollars out come from conversions, which will also be tax free since the tax was paid upon conversion.
But there’s a catch: If converted funds are not held for 5 years, withdrawals of those funds, while tax free, can be subject to a 10% penalty if withdrawn before age 59 ½. Once the converted funds are exhausted, the last funds out will be the earnings, which are more likely to be hit with tax and penalty if withdrawn before the 5 years and age 59 ½.
Coronavirus-related distributions
What a difference a few months make! Following the coronavirus outbreak, which hit our shores earlier this year, came legislation, the CARES Act, which created coronavirus-related distributions (CRDs), a source of funds available for those who qualify. The CARES Act allows up to $100,000 of IRA or company plan funds to be withdrawn in 2020 penalty-free. Clients need to be reminded, however that the funds are taxable.
The good news is that the income can be spread over three years, and the funds can be repaid over that time to eliminate the tax bill (assuming funds are available). To qualify for CRDs, a person, or the spouse or dependents, must have COVID-19 or the person with the plan or IRA must have suffered adverse financial consequences from a loss of income relating to the virus.
Although the three-year income spread is a good tax break, advisors should check the client’s tax situation to see if it might pay to include all the income in one year, if that year will produce a lower tax bill. For some clients, that just might be the case for 2020.
CRD loophole for hardship withdrawals
Company plans are not obliged to allow CRDs, but those that don’t may allow hardship withdrawals for pressing financial needs such as coronavirus-related expenses.
Hardship distributions are generally taxable, subject to the 10% penalty and cannot be rolled back over. However, if the employee is an affected person under the CRD qualifications above, the employee can treat these 401(k) hardship distributions as CRDs on his own tax return. This would make them penalty-free and allow the 3-year income spread and the repayment (rollover) option, effectively turning hardship withdrawals into CRDs.
On the clock: Plan loans and CRDs
Many companies offer loans from retirement plans. While generally not a good long-term financial move, these loans can help when funds are immediately and urgently needed. Unlike most other distributions, these loans are not taxable income when taken BUT they will be if not timely paid back.
The CARES Act provided relief here, allowing plans to double the maximum loan amount from $50,000 to $100,000 (reduced by other outstanding loans) for affected individuals, under the same tests that apply to CRDs.
But the clock is running. This relief is only available for loans taken by September 22, 2020 (180 days from the March 27 enactment of the CARES Act). What’s more, the plan allows any loan repayments due between March 27 and Dec. 31, 2020 to be suspended for one year. Interest does, however, continue to accrue. Loans are not available from IRAs.
Navigating 10% penalties on early distributions
If the client is under age 59 ½, he may qualify for any of the numerous exceptions to the 10% penalty. But be careful: Some exceptions are dependent on where the funds are withdrawn from. For example, some of the exceptions like those for higher education, first-time homebuyer or health insurance for the unemployed, are only available for IRA withdrawals.
If a client withdraws funds, for example, for higher education costs from a 401(k), that withdrawal will not qualify for the penalty exception. In that case, the client would be better off rolling the funds to an IRA (if rollover-eligible from the plan) and then withdrawing the funds penalty-free from the IRA.
If the plan funds are not eligible for rollover, then see if a plan withdrawal might qualify as a penalty-free CRD.
Other penalty exceptions apply only to distributions from company plans and not IRAs. These include the age 55 (50 for public safety employees) exception for employees who separate from service in the year they reach that age, or in later years. The key here is the date of separation from service, not the date of the distribution: If an employee separates from service at age 53 but doesn’t withdraw until age 55, she doesn’t qualify for the exception.
This exception does not apply to IRAs, so if clients need to access 401(k) funds early, advise them not to do an IRA rollover, even if they have lost their job. They’ll have to wait until age 59 ½ to access IRA funds penalty free.
- Section 457(b) The break on these governmental plans are not well known, but employees in these plans are not subject to the 10% penalty. If these funds are rolled to an IRA, However, this exception is lost.
- QDROs: Withdrawals from a qualified domestic relations order are not subject to the 10% penalty, but not if the funds are rolled over to an IRA and withdrawn from there.
10% penalty exceptions that apply to plans and IRAs
IRA or plan beneficiaries are never subject to the 10% penalty due to the death exception. For those who are disabled under the strict IRS definition of not being able to work, or those taking withdrawals used for medical expenses that exceed 7.5% of AGI (even if not itemizing) or so called 72(t) payment plans, these distributions are exempt from the 10% penalty whether taken from plans or IRAs. The 10% penalty also does not apply if plan or IRA funds are levied by the IRS.
The SECURE Act added a new exception for withdrawals taken within one year after a birth or adoption for up to $5,000 per child. This exception also applies to both IRAs and company plans. Plus, unlike the three-year time limit for CRDs, these distributions can be repaid to an IRA or plan at any time.
IRA rollovers: Sidestepping red tape
Generally, if a person has lost her job, 401(k) or other company plan funds will be eligible for an IRA rollover. Assuming the IRA rollover doesn’t expose funds to creditors or nullify a 10% penalty exception only available from a company plan, the IRA rollover will give clients more control over their funds if they are needed for emergencies — without going through the bureaucracy and red tape that can delay withdrawals from company plans. This is especially true now, when many HR staff are not available for assistance.
While retirement plan withdrawals should be a last resort, advisors can help make those funds less taxing when clients are in need. This is yet another high value helping hand your clients will remember you for.
Not for low-bracket clients?
It’s important to note that, although this article discusses ways to avoid taking taxable distributions, it may not be the right strategy for all your clients.
Due to loss of substantial income this year, for instance, some clients may find themselves in a very low tax bracket, which would allow them to withdraw their retirement funds with a minimal hit from Uncle Sam. It pays to run this by their tax accountants to project the tax cost.
Also, it may pay for clients in their late 60s to withdraw retirement funds at lower rates rather than taking reduced Social Security benefits early. Those benefits would be better delayed to age 70, when larger monthly benefits can be locked in for life.
