Should you take a COVID-Related Distribution (CRD) from your retirement account?
Tax Changes in the Pandemic Age
The global pandemic has generated a slew of tax law changes designed to ease the financial pain of millions of Americans whose physical, emotional, and financial health has been impacted. A summary of these changes is presented in the following article CARES Act: Highlights of the Tax Provisions. While many of these rules pertain specifically to 2020, the ramifications of some of the changes extend into future tax years as well.
One particular provision of the CARES Act that I believe warrants greater attention is the allowance of COVID-Related Distributions (CRDs) from IRA and retirement accounts. Under this provision, individuals who have been affected by COVID-19 (the definition of “affected” is broad, but not yet clearly defined) may withdraw up to $100,000.
There is no penalty for taking the distribution, even for recipients who are under age 59 ½. Any portion of the distribution that is repaid to the account or to a different IRA within 3 tax years of the distribution will not be subject to income tax. Thus, for recipients who intend to repay the funds, the CRD amounts to an interest-free loan from his/her retirement accounts.
The attraction to taking a CRD is that it may provide funds to help pay down debt and/or help families make ends meet without taking on high interest consumer debt. The CRD has certain advantages over a 401(k) loan insofar as there is no loan repayment schedule and there is no interest owed to the plan if the recipient wishes to repay some or all of the money.
One potential application of the CRD that has received zero media attention is that the CRD may give 401(k) participants in plans with few investment options or high expenses an opportunity to take $100,000 and eventually repay it to an IRA with lower fees and broader investment selection. Most 401(k) plans do not permit participants to transfer money to an IRA until they are separated from service.
While a CRD does indeed amount to an interest-free loan, recipients should be aware that they will be required to pay tax on the amount of the distribution each year with the tax liability spread out over three years. If the money is entirely repaid to an IRA or retirement account, they will be entitled to get all of the tax paid on the CRD back as a refund, though the mechanism for this has not yet been clearly established.
The other obvious pitfall of a CRD is that money that is distributed is no longer growing for retirement. However, if a portion of the 401(k) money is currently invested in low interest fixed accounts or bond funds, the opportunity cost may be negligible. However, the larger fear in the financial planning community is that this easy access to retirement savings will have serious long term effects on retirement savings balances for consumers who take the CRDs and do not return in to a retirement account within three years.
Consumers who wish to take a CRD must do so prior to December 31, 2020, and should understand that a tax bill for 1/3 of the distribution will be owed on their 2020 tax year. In my opinion, the CRD may be a better choice for many consumers than a 401(k) loan, and may make a great deal of sense for consumers who are wallowing in high interest credit card debt or struggling to make rent or mortgage payments. However, consumers should carefully consider whether they will have the ability to repay the distribution amount within three years, whether they will be able to manage the annual tax liability from the distribution, and the long term impact the distribution may have on his/her retirement savings. Consumers should definitely consult with their CPAs before electing to take a distribution.
John H. Robinson is the founder of Financial Planning Hawaii and a co-founder of software maker, Nest Egg Guru
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