The recent CARES Act made it easier for 401k plan participants to withdraw money from their accounts. In order to allow what are being called COVID-19 withdrawals from your 401k plan, you would need to amend it. However, I don’t believe you should adopt provisions allowing your 401k plan to permit COVID-19 withdrawals.
The CARES Act eliminated the 10% penalty tax normally assessed on withdrawals from 401k plan accounts prior to age 59 ½. The 20% tax withholding requirement was also dropped.
Although these COVID-19 withdrawals will still be taxable for participants at their incremental state and federal tax rates, participants may spread taxes owed over three-years.
The CARES Act also provides participants three years to pay these withdrawals back to their 401k plans. Amounts redeposited into plans won’t be subject to taxation.
You should know that the CARES Act does not require participants who take these withdrawals to show evidence of financial hardship or loss, as would be required under normal hardship withdrawal provisions.
Eligibility to take a COVID-19 withdrawal
The CARES Act restricts COVID-19 withdrawals to 401k plan participants who have:
Been diagnosed with COVID-19;
A spouse or dependent who has been diagnosed with COVID-19;
Experienced adverse financial consequences as a result of being quarantined, furloughed or laid off or having their work hours reduced; or
Been unable to work because of a lack of child care due to COVID-19.
Withdrawals are permitted for participants who have experienced these situations from January 1 through December 30, 2020.
To satisfy these requirements, it only appears necessary that participants certify they meet one of these criteria. In other words, it is not necessary for plan administrators (you) to verify that an applicant is eligible. You can take your employee’s word for it.
Why Allowing These Withdrawals is a Bad Idea
These CARES Act withdrawal provisions were enacted with good intentions. However, taking advantage of them will generally not be in most participants’ best interest. Here’s why.
1. Savings are likely permanently removed
Even though participants have the option of paying these withdrawals back, the vast majority won’t. Like 401k plan loans that become due immediately when a participant separates from service, most participants will not have the funds available to make repayment.
2. The impact of withdrawals likely is devastating
A significant number of participants who withdraw up to $100,000 from their 401k plan accounts will destroy their chances of retiring with a sufficient balance. The average participant taking a large withdrawal may never be able to build a retirement ready balance.
3. Bankruptcy protections should be considered
The potential that a participant may have to declare bankruptcy is critical when considering these withdrawals.
Participants who attempt to avoid bankruptcy by taking COVID-19 withdrawals, and end up declaring bankruptcy anyway did not have to lose their retirement money.
Funds held in qualified retirement plans are not subject to bankruptcy proceedings. Most participants are unaware that they can declare bankruptcy and protect their retirement savings.
Losing all of their personal and retirement savings at the same time will financially destroy many families. And it does not have to happen because retirement savings are protected. This is the worst possible scenario individuals with financial problems face – losing all their savings at the same time.
4. Shares are likely to be sold at a loss
It is a bad time to sell investments. Unless participants sell out of 401k investments that have experienced losses, they have only experienced paper losses. Selling shares to fund a COVID-19 withdrawal realizes losses (which are not tax deductible) in 401k accounts.
5. Enhanced unemployment compensation is available
Employees who have been furloughed are eligible to collect new higher unemployment benefits and may be eligible to take advantage of other benefits as well. Compared with other downturns in the economy, employees may be in a better position to survive.
6. This is a temporary situation
7. You can always change your mind
Don’t feel rushed to adopt COVID-19 withdrawal provisions. You can always change your mind and amend your plan to provide for these withdrawals if circumstances change.
An Alternative to Withdrawals
If you feel you need to provide greater employee access to 401k balances, and your plan permits loans, consider adopting the relaxed CARES Act 401k loan provisions instead of the withdrawal provisions.
While I normally don’t favor 401k loans, they are a better option than withdrawals during this pandemic.
Non-COVID-19 loans are subject to a limit that is the lesser of $50,000 or 50% of a participant’s vested balance. Loans taken from March 27 to September 23, 2020, may be up to 100% or $100,000 of a participants vested balance, whichever is less.
The CARES Act does not require participants to make loan payments during 2020 (although interest will still accrue).
Participants who take COVID-19 loans rather than COVID-19 withdrawals are much more likely to return funds to their accounts because they will be making loan payments.
Most recordkeepers have done an excellent job of quickly providing CARES Act amendment packages to their clients. Take the time to consider what will work best for your employees.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or firstname.lastname@example.org.
Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in Socially Responsible Investment (SRI) strategies for retirement plans and is a pioneer in the field. LRPC currently has contracts in place to provide consulting services on nearly a half billion dollars in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or email@example.com or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice, and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.