Amid the coronavirus (COVID-19) scare, we are getting reports that our clients are imposing layoffs, furloughs, and temporary shutdowns. It makes sense; if people aren’t coming to your business, there’s no work for the employees to do and no money to be made.
These clients are rightfully concerned about their employees’ ability to pay bills until normalcy returns to our world, whenever that may be. Aside from any wage continuation efforts that may be made, we are being asked what options the employees have or can be given as far as tapping into the money in their qualified retirement plans, particularly 401(k)s.
In this article, we will address steps that can be taken under regular pension rules as well as temporary measures granted by Congress. Future articles will speak to employer concerns about making contributions to their plans.
Options Generally Available
Here are some ways an employee may normally access their retirement plan money:
Termination or retirement. If a worker has terminated employment with the employer, usually their plan account balances may be distributed to them. These funds may be rolled over to IRAs or another workplace plan (which avoids immediate taxation) or paid directly to the former employee (which results in immediate taxation). Sometimes, a former employee may be required to wait for a few months or until the next year to receive the distribution. Employers may want to amend their plans to eliminate such waits, at least temporarily.
In-service distributions. As the name suggests, an in-service distribution is a distribution made to an employee who is still working for the employer. This may be helpful to certain employees who have not lost their jobs but have seen a reduction in hours worked. A plan may impose conditions on in-service distributions, such as minimum age or service. It may be that only part of an employee’s account is available for withdrawal.
Hardship withdrawals. A hardship withdrawal is a special kind of in-service distribution allowable only if there is immediate and heavy financial need where the employee lacks other available resources. Under the commonly used safe harbor rules, hardship distributions are allowed for medical expenses, purchase of a principal residence, education expenses, prevention of eviction or foreclosure, funeral expenses, or casualty losses to the principal residence. Job loss or a reduction in hours in and of itself would not qualify as a hardship under these rules. However, some plans allow the plan administrator be more lenient about what constitutes a hardship.
Loans. Some plans allow participants to borrow against their retirement account. Participant loans are supposed to be paid back, unlike in-service distributions and hardship withdrawals which do not need to be paid back. A loan would be useful mainly to someone who is still employed, not to a terminated participant, since loans generally are not available to terminated employees. More likely, terminees will simply have their account balance paid to them.
If a loan is made to an employee not receiving a paycheck because there is currently no work for them, some arrangement will have to be made about making repayments since normally repayments are deducted from the paycheck. A loan that is not repaid as scheduled will result in taxable income. Employees and employers should avoid making loans with an understanding that they will not be repaid. Such bogus “loans” will be declared as distributions, which may or may not comply with the terms of the plan.
We were asked recently whether an employee that was being furloughed could have the scheduled loan repayments suspended. This question came in before the new legislation described below was proposed. The answer is, a furlough is a leave of absence, and employees on a leave of absence may have their repayments suspended for up to a year. The missed payments would eventually have to be repaid with interest. Refinancing the loan is sometimes an option.
There are a few things to note about the above options:
- A plan does not have to allow in-service distributions, hardship withdrawals, or loans at all. Just because they exist in some plans doesn’t mean they are available in all plans.
- We do not take a position as to whether allowing in-service distributions, hardship withdrawals, or loans is a good thing or not. We are simply mentioning them as options for employers to consider when their employees are in a pinch. All of the options carry a certain amount of administrative hassle. It is also better for retirement planning’s sake to leave money in the plan rather than withdraw it. However, there may be times when the immediate need overrides preparation for a retirement that is years down the road. That is a conversation for the employee to have with his financial advisor.
- Plan sponsors must always follow the terms of the plan. If an employee wants money from the plan, make sure the plan allows it. If it doesn’t, amend the plan if possible. Don’t go against the plan terms just because you want to help employees who have a dire need. (However, see below about a temporary exception.)
If the existing rules did not give employees the relief they sought, there is a new law that goes further. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, the third phase of Congress’ response to the COVID-19 pandemic enacted on March 27, 2020, provides for the following:
- Individuals affected in various ways by COVID-19 may receive distributions of up to $100,000 on or after January 1, 2020, and before December 31, 2020 for which the 10% early withdrawal tax under Internal Revenue Code Section 72(t) will not apply. The income may be spread out ratably over three years for tax purposes. The employee has the option of repaying the distributions within three years. These distributions will not be subject to the usual 20% federal tax withholding, meaning the employee will need to pay the full income tax amount when his return is filed, albeit not the 10% early withdrawal penalty.
- The loan limit is temporarily increased for 180 days from $50,000 to $100,000. The participant may borrow 100% of his vested account balance rather than just 50%.
- Any loan payments due in 2020 may be delayed for a year. When eventually made, the repayments will need to be adjusted for interest. If the maximum five-year loan period would otherwise expire, it may be extended to the end of the one-year delay period.
- Required minimum distributions (RMDs), which generally apply to those age 72 and older, are suspended for 2020 in defined contribution plans (but not defined benefit plans). This provision obviously is not intended to grant employees easier access to their retirement money. Rather, it eliminates the need for employees to liquidate their investments at a time when they may be severely depressed in value and take a distribution that is out of proportion to the current, lower account balance.
- A plan is able to start implementing these rules immediately. The plan does not have to be amended until the last day of the 2022 plan year, or later if the Secretary of the Treasury so prescribes.
Note: This post has been updated to reflect passage of the CARES Act. As of the original writing, the CARES Act was a proposal in the Senate which did not contain the suspension of RMDs.