Coronavirus Relief Sets Low Bar for Raiding Retirement Accounts

Retirement account holders impacted by the novel coronavirus can withdraw $100,000 with few restrictions thanks to the bipartisan relief package signed into law last week.

The new law scraps a 10% penalty for pre-retirement withdrawals on up to $100,000 this year from qualified plans such as 401(k)s to offset “adverse financial consequences” due to the virus, and allows for repayment of the funds within three years.

The extraordinary combination of tax breaks, nebulous criteria, and repayment options makes coronavirus withdrawals far more attractive than existing IRS exemptions, according to retirement professionals.

“Congress has created a whole new category of distribution options,” Robert Neis, a partner at Eversheds Sutherland, told Bloomberg Law. “We’ve never seen anything like this.”

The special treatment granted to coronavirus withdrawals is more expansive than the temporary tax relief typically adopted after a natural disaster or relaxed access provided following traditional life-changing events, said Mark Iwry, an Obama-era Treasury Deputy Assistant Secretary for Retirement and Health Policy now at the Brookings Institution.

“It matters because hardship withdrawals are subject to different rules and restrictions,” Iwry said of this latest development.

Less Hassle

Retirement account holders who previously wanted early access to their accounts had to reside in a geographic area impacted by a natural disaster, or face an “immediate and heavy financial need” typically associated with medical bills, housing costs, or funeral expenses.

Groom Law Group benefits attorneys David Levine and Elizabeth Dold said the stimulus considerably broadens who is privy to emergency withdrawals.

“Because of both administrative complexities and different positions taken on triggers for the FEMA disaster hardship safe harbor in IRS guidance, we anticipate the coronavirus-related distributions will be the main approach for many plans,” Levine said in an email.

“Even though the relief is optional, we anticipate many plan sponsors will take advantage of it to assist their employees in these very difficult times,” added Dold.

Neis said workers who’ve been laid off or furloughed during the coronavirus outbreak clearly qualify for immediate access to retirement funds under the stimulus law’s “adverse financial consequences” construct. Same goes for anyone who tests positive for the virus—since a medical diagnosis would naturally generate a paper trail, he said.

Everyone else, including those whose pay has fluctuated while under work-imposed quarantine or who’ve watched their retirement account balances plummet with each stock market mood swing, is presumably on the honor system.

“You don’t have to actually demonstrate that you need the money to get it,” Neis said of the changes imposed by the stimulus law.

Iwry said he has no problem with the decision to release retirement funds to those who’ve tapped every other resource “and need their plan account to live on.” But he said he’s worried that promoting this $100,000 amount creates “an invitation to jump through this window” by folks in not-so-dire conditions.

“There’s an endorsement effect going on here,” Iwry said. “The government and my employer both seem to want me to have and consider this option.”

New Wrinkles

Stripping away the early withdrawal penalty on emergency funds isn’t the only tax consequence retirement account holders need to consider.

Under the new law whatever coronavirus-related funds account holders withdraw would count as income. Individuals could spread the withdrawal out evenly over the next three years but are still liable for the corresponding income tax.

Iwry said his interpretation of the stimulus law is that the 10% penalty is waived “no matter what,” but the “presumption” is that the Internal Revenue Service will later have to “undo the tax” for those that take out money, divvy it up, and eventually repay the distribution.

“You’re taxed ratably over the three-year period, but if you repay the distribution during that time, there will be a true-up,” Iwry said. “It’s not as if you get to avoid the tax before you repay it.”

Neis views the repayment issue as one that needs further explanation from tax officials.

“How all those rules are going to come together is unclear,” he said. Neis discussed how amended tax returns and deductions could play into a regulatory fix in a recent newsletter.

Something else Iwry said account holders must contend with is how spreading out emergency funds will affect future tax filings.

He estimates that the amount of emergency funds allotted as income for each of the three years should remain static. What could vary are the taxes owed during each filing season depending on which income bracket one lands in.

For example, adding 1/3 of the withdrawal amount to the full-time salary earned by an individual with no workplace-related changes this year may bump that person into a higher tax bracket. Should they lose their job because of the health-care crisis, combining 1/3 of the withdrawal amount solely with unemployment benefits collected in 2021 would likely place them in a lower tax bracket. If they’re working part-time or have switched careers, adding 1/3 of the withdrawal amount to whatever income they generate in 2022 could move them in an entirely different tax bracket than the prior two years.

The individual would have to make sure their tax payments matched up each step of the way.

Best Behavior

Iwry said the self-certification language in the stimulus law about withdrawing emergency funds is designed to protect plan sponsors. But it also shields Treasury from having to “second guess” why account holders dug into their retirement savings.

“They can accept that Congress decided to make it pretty easy to make these withdrawals,” he said, adding that the criteria “are broad enough that most of those who want to use this should qualify.”

If history is any guide, Neis said the emergency withdrawals shouldn’t draw too much attention from IRS auditors.

“The IRS has already gotten pretty comfortable with a low level of proof on hardship distributions. They kind of trust an employee is telling the truth that they need the money,” he said.

The IRS didn’t respond to requests for comment about enforcement efforts surrounding hardship distributions.

Veena K. Murthy, a former legislation counsel for the nonpartisan Joint Committee on Taxation turned partner at Crowe LLP, warned plan sponsors against taking anything for granted.

“It’s possible that when this is all over the IRS looks back at this and makes sure it was all done properly,” she said.