Updated May 02, 2022
Many Americans faced—and continue to face—financial hardships due to the COVID-19 pandemic, prompting regulatory updates aimed at providing relief and support. The Coronavirus Aid, Relief and Economic Security (CARES) Act allows people who have been impacted by the pandemic to withdraw funds from their 401(k) plan without penalty. This is a viable option that is akin to a PPP loan, but those were more focused on businesses and not individuals.
Depending on the situation, taking an early distribution from a retirement account may be a viable option. Here’s what retirement account owners need to know.
Key takeaways:
Normally, participants who withdraw money from a tax-deferred retirement account before reaching age 59½, must pay a 10% early withdrawal penalty in addition to including the distribution in their taxable income for the year.
There are a few exceptions to the rule, including one for hardships, such as avoiding foreclosures, repairing your home after a disaster, or covering out-of-pocket medical expenses. However, these hardship withdrawals are normally limited to the amount needed to meet a limited list of hardships.
The CARES Act provided more flexibility for making emergency withdrawals from a tax-deferred retirement account by eliminating the 10% early withdrawal penalty. Participants are allowed to withdraw up to $100,000 per person without being subject to a tax penalty. Any early withdrawals above that amount don’t qualify for special tax treatment.
Similar to figuring out PPP loan tax implications, it is important to note that there are tax implications for this type of loan as well and that the withdrawal is taxable income — the special tax treatment waives the tax penalty but not the taxable event. However, the CARES Act allows people who take hardship distributions to elect to pay federal income taxes on the distribution over a three-year period or repay the distribution amount over a three-year period and avoid tax consequences entirely. The three-year repayment period starts on the day of the distribution.
Although the initial provision for penalty-free 401(k) withdrawals expired at the end of 2020, the Consolidated Appropriations Act, 2021 provided a similar withdrawal exemption, allowing eligible individuals to take a qualified disaster distribution of up to $100,000 without being subject to the 10% penalty that would normally apply. This extended the timeline for penalty-free distributions through June 25, 2021.
For IRA and 401(k) account owners in their retirement years, the CARES Act also provided financial relief by allowing account owners to forgo required minimum distributions in 2020.
The IRS explains those qualifications in more detail in Notice 2020-50, Guidance for Coronavirus-Related Distributions and Loans from Retirement Plans Under the CARES Act.
Both traditional IRAs and employer-provided retirement plans, such as 401(k) and 403b plans, are included in the legislation. However, Nonqualified plans and 457f plans are not eligible.
Employers can opt not to allow pandemic-related distributions from their plans, and some have chosen not to. If your employer does not offer pandemic-related distributions, participants may still qualify to take a hardship distribution under another covered financial hardship category.
Even if the plan doesn’t offer COVID-19 pandemic-related withdrawals, the IRS will treat the withdrawal as a CARES Act withdrawal as long as the taxpayer is a qualified individual. The participant will need to complete Form 8915-E, Qualified 2020 Disaster Retirement Plan Distributions and Repayments, and submit it with their tax return.
All qualified distributions taken in 2020 qualify, even if the participant took the withdrawal before the CARES Act passed on March 27, 2020.
Plan participants should speak to their plan administrator to ask about the process for requesting a 401(k) or IRA withdrawal. The participant may need to complete a withdrawal form and provide documentation to substantiate the nature of their hardship.
The request will need to be approved by either a committee or a designated person responsible for making hardship-withdrawal decisions. If the participant qualifies for a hardship withdrawal based on IRS regulations, the plan administrator will process the request. Depending on the plan administrator, approving and processing the hardship request can take several weeks. For that reason, a hardship withdrawal may not be a great option for the most time-sensitive financial needs.
If the participant doesn’t qualify for the distribution, the administrator will deny the request and notify the participant.
Prior to the CARES Act, plans would automatically withhold 20% of early withdrawals for tax purposes. The CARES Act eliminated the 20% automatic withholding on 401(k) withdrawals. However, participants may want to avoid spending the full amount withdrawn in order to have funds available to cover the tax bill later.
At the end of the year, the plan administrator will issue Form 1099-R to both the plan participant and the IRS. This form shows the distribution amount, the taxable portion (when available), and any tax withheld. Participants should use this form to complete their individual tax return, Form 1040. The taxpayer will also need to complete Form 8915-E and submit it with their tax return.
If you have any questions or need assistance preparing for regulatory compliance, contact our audit experts.
