The Pros and Cons of Using Retirement Accounts for Emergencies

As businesses and individuals continue to feel the financial impacts of the COVID-19 pandemic, some taxpayers might be considering tapping into their tax-qualified retirement accounts, either to keep their businesses operating or to meet personal cash needs. Certain provisions of the Coronavirus Aid, Relief, and Economic Security (CARES) Act made this strategy more accessible for many taxpayers.

Business owners, plan administrators, and individual taxpayers considering such a move should familiarize themselves with the CARES Act’s special rules, as well as the general advantages and disadvantages of using retirement accounts to manage temporary cash shortfalls.

Basic Factors to Consider

There are good reasons why financial advisors caution against using retirement funds to meet short-term needs. In addition to missing out on the potential investment gains their accounts might achieve, taxpayers who withdraw funds from tax-qualified plans before reaching age 59½ also incur significant tax penalties.

Taxpayers with employer-sponsored accounts such as 401(k) plans can avoid the immediate tax penalties by borrowing from their accounts instead of taking early withdrawals. (Loans cannot be taken from IRAs.) Nevertheless, such loans must be repaid within strict deadlines to avoid being reclassified as an early withdrawal.

Despite these concerns, some taxpayers might find it necessary to take cash out of their retirement accounts to address coronavirus-related financial pressures. Section 2202 of the CARES Act was designed to make that somewhat easier.

Who Qualifies for the New Rules

The CARES Act’s special distribution rules are available only to taxpayers who were adversely affected by the pandemic in at least one of the following ways. To qualify, a retirement account holder must certify that he or she:

  • Was diagnosed with COVID-19 or has a spouse or dependent diagnosed
  • Suffered adverse financial consequences from being quarantined, furloughed, laid off, or having work hours reduced
  • Is unable to obtain work because of a lack of childcare due to the virus
  • Was forced to close or reduce hours of a business he or she owns or operates

IRS Notice 2020-50 later expanded this list to include self-employed workers, as well as taxpayers who had other household members suffer any of the adverse financial consequences listed in the Act.

CARES Act Changes

For those who meet one of these qualifications, the CARES Act waives the 10 percent penalty that is normally imposed on early distributions from retirement plans. The distributions must still be reported as income, but qualifying taxpayers may report the income ratably over a three-year period instead of entirely in the year the distribution was received. Furthermore, if they repay their distributions within three years, they may treat them as tax-free transfers and request refunds of the relevant taxes. These distributions must be taken before December 31, 2020 and are limited to $100,000 per taxpayer.

The CARES Act also relaxes the rules regarding loans from employer-sponsored plans. For coronavirus-related loans, it extends all payment due dates between March 27 and December 31, 2020 by one year and adjusts subsequent due dates accordingly. This effectively gives qualifying taxpayers six years to repay a new loan instead of the normal five. An earlier rule change already gave taxpayers additional time to repay loans if their employment is terminated.

The Act also temporarily increased the maximum amount that could be borrowed from a qualified plan, but that provision expired in September. The maximum loan amount has now reverted to $50,000 or 50 percent of the vested account balance.

The Employer’s Role

Just as employers are not required to allow loans from their 401(k) plans, they also are not required to adopt the CARES Act changes. However, even if an employer-sponsored plan is not amended, a qualified taxpayer can still treat a COVID-related distribution as eligible for the tax benefits allowed by the CARES Act.

Account holders do not have to prove how much they were adversely affected by the coronavirus, so plan administrators do not need to review bills and receipts to determine the qualifying amount of a loan as they normally would. Instead, employers may simply rely on the employees’ certification that they are eligible.

Employers who are considering whether to adopt the new rules—and individuals who are wondering whether to take advantage of them—should carefully consider all the pros and cons before making their decision.