10 Nov We have jobs. Can we take from our 401(k) plans without penalty?

Q. My wife and I are both working. The school our child is attending is having only virtual classes, Can we choose to withdraw from our 401(k) without penalty? Are there any other options under the CARES Act?
— Still working

A. We’re assuming from your question that you’re incurring extra expenses or losing income, or both, as a result of having your child at home instead of attending school in person. You may be in luck, if you act quickly.

Most distributions from retirement plans such as 401(k)s and IRAs are subject to income tax and may also be subject to a 10% penalty if you receive them before reaching age 59 ½, said Gene McGovern, a certified financial planner with McGovern Financial Advisors in Westfield.

That’s changed with the CARES Act, which was enacted on March 27, 2020. The new law allows “qualified individuals” to take “coronavirus-related distributions” from retirement plans of up to $100,000 without the 10% percent penalty. It also changes how the distributions are taxed, McGovern said.

These special distributions must be taken before Dec. 31, 2020, to qualify.

McGovern said the income from coronavirus-related distributions is taxed over three years unless the taxpayer elects to recognize it all at once. And if the distributions are returned to the account within those three years, there’s no tax at all.

Under the CARES Act, as well as subsequent IRS guidance published on June 19, 2020, a qualified individual is defined very broadly, McGovern said.

To begin with, a qualified individual is anyone who is diagnosed with COVID-19 or whose spouse is so diagnosed, he said.

“You don’t need to have been diagnosed with coronavirus, though, to be a qualified individual,” he said. “The definition also applies to any individual, to his or her spouse, or to a member of that individual’s household who — due to COVID-19 — experiences `adverse financial consequences.’”

Those include:
· being quarantined, furloughed, laid off, or having work hours reduced;
· being unable to work due to lack of childcare;
· having to close or reduce the hours of a business they own or operate; or
· having a reduction in pay or self-employment income, or having a job offer rescinded or start date for a job delayed.

“If you’re a qualified individual under any of these criteria, provided they are “due to COVID-19,” you can take a coronavirus-related distribution of up to $100,000 in the aggregate from any of your eligible retirement plans, such as your 401(k),” he said. “You must have taken it on or after Jan. 1, 2020, and before Dec. 31, 2020.”

The aggregate $100,000 limit applies across all your retirement accounts, he said. For example, if you take $25,000 from your IRA, you could also take up to $75,000 from your 401(k) or 403(b) plan as coronavirus-related distributions.

“Note that you can take the money out for any reason, regardless of need. According to the IRS, coronavirus-related distributions are not limited to amounts that you withdraw solely to meet a need arising from COVID-19,” McGovern said. “As long as you or your wife meet the definition of a qualified individual, you can take the money out for any reason, such as for child care expenses, tuition, or other purposes.”

Under the special rules of the CARES Act, you still have to pay tax on these distributions over three years — unless you recontribute the money within that time — but you won’t incur the 10% penalty that usually applies to withdrawals from retirement accounts made before age 59 ½, he said.

Even better, you have a choice of how to recognize the income for tax purposes. Under the default option, taxpayers recognize the distribution as income spread over three years, one-third each year. Alternatively, you can elect to include the entire amount in income in the first year, he said.

McGovern offered this example. Say Conrad withdraws $90,000 from his 401(k) plan on Nov. 15th, 2020. Conrad is a qualified individual and elects to treat the withdrawal as a coronavirus-related distribution. He will recognize $30,000 per year on his tax returns for 2020, 2021, and 2022, unless he elects to include the entire $90,000 distribution in income in 2020.

Conrad might want to make that election, for example, if he isn’t working or otherwise would be in a lower tax bracket in 2020 than in later years, he said.

Whichever method you choose to recognize the income, you can avoid any taxes by recontributing the money within three years to the same or another eligible retirement plan.

“In effect, this is an extended version of the standard 60-day rollover that individuals can already do once every 12 months, with the added bonus that it doesn’t count against that one-rollover-per year limitation,” he said.

The IRS will treat a recontribution of a coronavirus-related distribution made within three years as a direct rollover in a trustee-to-trustee transfer, which eliminates any taxes due, he said. You can make the recontributions in one or more payments over the three-year period.

Meanwhile, if you’ve already been taxed on all or part of a coronavirus-related distribution, you can file an amended return to get a refund, he said.

Take this example from McGovern: Jocelyn took a $15,000 distribution from her IRA in March 2020. She elects to include the entire $15,000 in her gross income for 2020 and pays the taxes due on it. In April 2022, Jocelyn recontributes the $15,000 to her IRA. She’ll need to file an amended income tax return for 2020 to report the recontribution and claim a refund of the taxes paid on the $15,000.

“If you are not eligible for CARES Act coronavirus-related distributions as described above, you may still be able to tap your 401(k) plan in two other ways,” McGovern said. “First, hardship distributions are often available from 401(k) plans to meet an `immediate and heavy financial need.’ Check with your plan administrator about this.”

Second, your 401(k) plan may permit you to borrow from the plan, McGovern said. Loan amounts are limited to 50% of your vested account balance up to a maximum of $50,000, and generally must be repaid within five years. Loan repayments must be made at least quarterly, and in substantially level payments, he said.

Finally, McGovern offers a note of caution.

“Retirement funds are best left untouched if you have any other potential source of funds that could be used instead,” McGovern said. “For any period of time that you take money out of a retirement account, even if you eventually pay it back, you lose the tax-deferred growth that the money would otherwise generate, and that can greatly reduce the amount you accumulate in the end.”

For example, taking out $100,000 from a retirement account for three years that would otherwise grow at 5 percent per year would mean permanently forfeiting $15,763 in growth, even if you pay back the $100,000 three years later, McGovern said.

“Moreover, if that same $15,763 had remained invested for 30 more years at 5 percent, it would have grown to $68,125,” he said. “So the cost of taking out $100,000 today can ultimately be as high as $68,000 or more forgone when you retire.”

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This story was originally published on Nov. 5, 2020.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.