Protecting the health of retirement plans during the COVID-19 crisis, Part II: Gaining access to retirement benefits

The COVID-19 crisis is creating major upheavals both in terms of people’s health and their retirement benefits. Employers and their employees are struggling to handle the stock market’s drastic downturn, the challenges of working remotely, the negative impact of declining business or total shutdown, and the isolation of sheltering in place.

Unfortunately, the coronavirus is also having a direct or indirect impact on an employer’s retirement plans. In part two of this three part alert, we will explore how employees may gain access to their retirement assets to handle the current financial struggles. Part one addressed how an employer can stop or reduce its contributions to its retirement plans, and the third part will examine how to address the effects of layoffs, Family First Coronavirus Response Act (FFCRA) payments and the stock market decline.

PART II - Gaining Access to Retirement Benefits

It is fairly obvious that the purpose of any employer sponsored retirement plan is to provide a vehicle for employees to accumulate an amount of money from personal contributions and employer contributions to be used in retirement. In challenging economic times, like the one created currently by the COVID-19 crisis, employees may feel compelled to try and gain access to such funds to handle immediate financial difficulties.

Because of the negative tax impact, accessing such funds may cause the depletion of a retirement fund, which may never get replaced. Accessing retirement funds for short-term needs is normally not the best solution. However, for many employees such funds may represent their only source of liquid cash.

Recognizing that economic reality, there are four ways that an employee may gain access to their retirement benefits.

Plan loans

Although it is not required, many plans permit loans as a technique to permit access to 401(k) funds. See below for the new liberalized rules for certain plan loans being introduced by the CARES Act. Under the Internal Revenue Code, with the exception of the CARES Act changes described below, the maximum amount a participant may borrow from his or her plan account is the lesser of $50,000 or one half of his or her vested account balance. The maximum term of such loan may not exceed five years.  However, if the purpose of the loan is to acquire the principal residence of the participant the term may be longer. A participant must make substantially equal payment of principal and interest at least quarterly. Although not required by law, the best practice is to require the repayment of plan loans through payroll deduction. This minimizes the risk of default. If the participant does default because he is no longer makes the required payments for whatever reason, the participant is deemed to have a taxable distribution. The plan should treat it as a distribution and report it to the IRS as such. 

Participants who have taken loans or who may take loans in response to the financial stresses may find themselves unable to make payments timely. The IRS has indicated that in the normal course, a participant may be able to cure missed payments if they make up the missed payments by the end of the calendar quarter following the calendar quarter when the payment was missed. This effectively translates into a three to six month “grace period.” Employers may have written loan policies which describe the cure period for missed payments which may be shorter than that. If employers wish to be more lenient given the current economic situation, the employer may wish to amend such policies.

Notwithstanding any “normal” grace period, the IRS has stated in its regulations that a participant on a bona fide leave of absence may have up to a year during which he or she does not need to make payments. It is not clear that a participant who is laid off could use the leave of absence exception to avoid loan payments for up to a year. The total length of the loan including the year exemption still may not exceed 5 years.

The participant still needs the cash to make up the payments. Failing to make payments can result in a default and the loan is then treated as a distribution. Again, see below for the changes made by the CARES Act.

Technically, a plan loan is an investment of the plan and the plan trustee or the fiduciary approving the loan is effectively making a fiduciary decision to grant the loan. Typically, the interest paid on the loan is credited to the participant who borrows the funds and in the event of default, it is the participant’s account that is reduced by the defaulted loan. Nevertheless, fiduciaries may wish to consider the creditworthiness of the borrowing participant. If it appears likely that the participant may not be able to pay back the note because he or she has been laid off or if the participant has defaulted on loans previously it may be prudent not to approve the loan. The counter argument is that the participant is only hurting him or herself.

Hardship distributions

An alternative that may be available is what is called a hardship distribution. Under the Tax Code, a 401(k) plan may not make distributions to participants while they are still employed unless the participant is 59½ or older or has incurred a financial hardship. Most plans utilize what is called the IRS “safe harbor” definition of hardship to permit a taxable hardship distribution without an exhaustive and potentially embarrassing review of a participant’s financial condition. The “safe harbor” definition of hardship means an immediate and heavy financial need for one or more of the following purposes: 

  • Deductible medical expenses for the participant, his spouse, or dependents.
  • Purchase of the participant’s principal residence (but not mortgage payments).
  • Payment of tuition for the next quarter or semester of post-secondary education for this participant, his spouse, children, or dependents.
  • Preventing eviction from the participant’s principal residence, or preventing foreclosure on the mortgage of the participant’s principal residence.
  • Payments for funeral or burial expenses for a deceased parent, spouse, child or dependent.
  • Expenses to repair damage to a principal residence that would qualify for a casualty loss deduction.
  • Expenses related to damages in a disaster area declared under certain federal laws, provided the participant’s principal residence or principal place of work was in the disaster area.

By limiting financial hardship to these “safe harbor” categories, the plan fiduciaries can rely on the participant’s representation that he or she satisfies a particular safe harbor hardship category. However, if the fiduciary has reason to believe that the participant is misrepresenting his or her financial condition for the request; the fiduciary who permits the hardship distribution is permitting a distribution in violation of the Tax Code and, is thereby risking the tax-qualified status of the plan for the remaining participants.

The question that has been asked is whether coronavirus layoffs or other financial problems that are related to coronavirus satisfy the requirement to permit hardship distribution. The technical  answer right now is they do not. However, the CARES Act described below may effectively permit plans to treat certain distributions related to the coronavirus as satisfying the hardship rules.

In service distributions

Some plans have provisions which permit a participant to take a distribution while still employed. This is sometimes referred to as an “in service distribution.” Under the Tax Code, a plan can permit an in-service distribution under certain circumstances. Typically, a plan can permit a distribution if the money has been in the plan for a set period of time (typically no shorter than two years) or after attaining a set age. 

Because 401(k) plans are not permitted to distribute salary deferral contributions before attaining age 59 ½, many plans that permit in service distributions use that age for distribution of any money sources. Other plans only permit distributions after the participant attains Normal Retirement Age under the plan.

If a participant wishes to use this provision, he or she needs to determine what events permit in service distributions—whether it is age based or a set period of time that the funds have been in the plan. 

Termination distributions

Finally, the last source of receiving a distribution is termination of employment. Virtually all plans permit a distribution of benefits relatively quickly after a participant terminates employment. There are some plans that do not permit a distribution of benefits until normal retirement age regardless of when a participant terminates employment. These are rare, and usually the restriction applies to employer contributions and not employee 401(k) contributions. 

It is probably never a good idea to quit solely to receive a distribution of a participant’s benefit. However, some people may be tempted to do so if they have no other access.to those funds. Because many employers maybe laying people off as a method to weather the economic storm, laid off employees may perhaps justifiably see themselves as terminated and request a distribution of benefits.  It is not really clear whether a “laid off” participant is actually terminated. If the layoff is relatively short-- maybe only a few weeks and the participant is called back – there is a risk that the IRS could see the participant as not being really “terminated.”  As a practical matter, it may be best to wait before making distributions on the basis of termination if there is a strong likelihood that the participant will be recalled.

Tax consequences

Unless the distributions are distributions of Roth Deferrals or some other form of after tax employee contributions, the distributions discussed here are all taxable as ordinary income to the participant. For any distribution which could be rolled to an IRA (which is pretty much all the distributions listed here) the trustee is required to withhold 20% for federal income tax.  In addition, unless the distribution satisfies the rules discussed below for certain distributions under the CARES Act, if the participant is less than  59½ years old, the distribution is subject to an additional 10% penalty tax as an early distribution.

The upshot of the tax consequence is that retirement money is an expense source of cash in an economic downturn.

Coronavirus relief legislation

In response to the need for participants to access funds in this time of economic stress, the recently enacted  Coronavirus Aid, Relief and Economic Security Act (CARES Act), may create some relief. 

  • The CARES Act would create an exemption from the 10% penalty tax for distributions before age 59 ½ for distributions from eligible retirement plans (which includes IRAs) in 2020 up to $100,000, if the distribution is a “coronavirus-related distribution.” These are distributions to participants who: have been diagnosed with coronavirus or has a spouse or dependent diagnosed; are quarantined, laid off or unable to work due to a lack of childcare or the closure of a business.
  • If a distribution from a plan  is a coronavirus related distribution it would be deemed to be in compliance with the restrictions on distributions applicable to certain plans like 401(k) plans. This would mean that the distribution would be permitted in a 401(k) plan even though it was before age 59 ½ while the employee was still employed or if it did not otherwise satisfy the ”safe harbor” hardship rules.
  • Coronavirus-related distributions would be included ratably in income over three years, unless the participant elects out of the three year deferral.
  • Employers would be allowed to rely on the participant’s certification that the distribution is a “coronavirus-related” distribution. The law provides guidance on withholding and when plans need to be amended to permit such distributions.
  • The law permits repayment of coronavirus-related distributions within three years to be treated as tax-fee rollovers.

The law also increases the loan amount available from plans for participants who satisfy the requirements to be able to receive a coronavirus-related distribution to the lesser of $100,000 or 100% of the participant’s vested benefit and delays the due date for loan payments due in 2020 for a year. These increased limits and extended payment are only available for loans made during a 180 period beginning on the date the CARES Act was enacted.

Conclusion

During these challenging economic times, financially-strapped participants will no doubt be looking for sources of cash wherever they can find them. While employers will be sympathetic to such needs, employers need to be mindful of the terms of their retirement plans and the tax rules and consequences of such access.

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