As if the passage of the SECURE Act on January 1st of this year did not create enough upheaval in the world of qualified retirement plans, along came the “Coronavirus Aid, Relief and Economic Security” Act (the CARES Act) on March 27, 2020 and added even more. The CARES Act upends the fundamental rules for who must, and who may, take distributions from qualified retirement plans such as IRAs, 401ks, 403(b)s and 457 plans in 2020.
A Refresher on Qualified Retirement Plans
Qualified retirement plans such as 401ks and IRAs allow people to set aside some of their earned income for their retirement in a tax-favored way by deferring the income tax due on the funds contributed to the plan until such time as the funds are withdrawn. Roth plans work the opposite way – they are funded with post-tax dollars but no tax is owed on amounts withdrawn. In both types of qualified retirement plans, the funds in the plan grow tax-free.
As the purpose of these plans is to encourage people to save for retirement, the law discourages withdrawals prior to age 59.5 by imposing a 10% penalty on amounts taken out of the plan before reaching that age.
On the flip side, since the government wants to collect the tax on these monies eventually, the rules governing qualified retirement plans require that a certain amount be withdrawn each year once the owner reaches age 70.5 (age 72 beginning in 2020 thanks to the SECURE Act). The amount required to be withdrawn each year from a traditional retirement plan is the Required Minimum Distribution (RMD), sometimes called the Minimum Required Distribution (MRD). (Note that individuals who fund a Roth IRA or 401K are not required to take withdrawals during their lifetimes.) Whatever you call it, this amount MUST be withdrawn from the plan and the owner must pay income tax on the amount withdrawn. In fact, the government is so adamant about this withdrawal that the law imposes a 50% penalty if someone fails to take the full amount of their RMD in any one year. But not in 2020!
Individuals Required to Take Minimum Distributions are NOT Required to do so in 2020
The CARES Act eliminates the requirement that a person who has reached his required beginning date (i.e. age 70.5 before January 1, 2020) take an RMD in 2020. For people with large retirement plans who do not need their RMD to pay their expenses, this is a tremendous benefit. Not only will the amount of the RMD remain in the qualified retirement plan and continue to grow tax free, but the income tax due on the distribution is avoided. For example, if the RMD on a $1 million IRA is $50,000, not having to take those funds might save $10,000 in tax (15% federal and 5% in Massachusetts). This is not a deferral of the tax; this is a complete avoidance of it.
Individuals who took a Distribution in 2020 but Wished They hadn’t may put it back
Not only does CARES allow people to skip their RMD for 2020, but it allows people who took their RMD out of their IRAs earlier in the year to return the funds and avoid the tax. However, you must return the funds to your IRA by August 31, 2020. If you are in this situation, contact your tax advisor or the custodian of your retirement account as soon as possible to make sure you comply with the rules for returning the funds before the deadline.
Individuals who would have been Penalized for Taking Distributions from Qualified Retirement Plans may be able to do so without Penalty in 2020
Under CARES, if a person under the age of 59.5 is a ‘qualified individual’ he may withdraw up to $100,000 from qualified retirement plans in 2020 without incurring the 10% penalty. In addition, a qualified individual may spread the tax due on the distribution over a 3-year period. Alternatively, a qualified individual may re-pay the distribution to the plan within three years and never pay the tax on the distribution – kind-of like a tax-free loan from yourself.
Under CARES, a ‘qualified individual’ eligible for this favorable treatment, is:
Either a person who is diagnosed with COVID-19, or whose spouse or dependent is diagnosed with COVID-19;
Someone who experiences ‘adverse financial circumstances’ (or whose spouse or household member does) as a result of the pandemic.
The Act includes a number of examples under which ‘adverse financial circumstances’ may occur (being laid off or furloughed, losing child care, being quarantined, or experiencing a reduction in pay) and does not otherwise define adverse circumstances.
The provisions of the CARES Act applicable to qualified retirement accounts can provide significant financial benefit for people who find themselves in either of these circumstances – over age 70.5 and not in need of the annual RMD, or under age 59.5 and in need of funds. The above is a summary of these rules and of course the devil is in the details. If you want to learn more about your options under CARES, reach out to your tax or financial advisor to learn how the specific provisions of the Act apply to your situation.