One of the most popular articles published last year by PLANADVISER Magazine—called “Warn Your Clients: Don’t Abuse Coronavirus Hardship Withdrawals”—went live in early June.
As readers likely recall, an important provision of the Coronavirus Aid, Relief and Economic Security (CARES) Act established a window within which retirement plan participants negatively impacted by the pandemic could withdrawal up to $100,000 penalty-free from their tax-qualified accounts, with the options of either spreading the stated income over a three-year period for taxes or paying back the funds later to avoid taxation altogether. The June article noted how plan participants could simply self-certify that they had experienced a pandemic-related hardship that qualified them to take such a distribution—and how this could potentially generate fiduciary risk for plan sponsors and even the possibility of tax fraud being committed on the part of unwitting or dishonest participants.
Robert Lawton, president of Lawton Retirement Plan Consultants, was among the experts cited in the article. Speaking again with PLANADIVSER this week, he did not seem surprised to learn about the success of the article, given how many questions and comments he continues to hear from his clients about coronavirus-related distributions, or “CRDs.”
PLANADVISER: You voiced some concern last year when the CRD framework was first set up that plan sponsors might have felt compelled to allow such distributions from their plans, even in cases where they felt their plan population was not suffering severe financial consequences that would justify taking money out of the retirement plan. Did this happen very often, in your experience?
Lawton: I was surprised at how this played out with my clients. Most of the plan sponsors that I work with from smaller companies chose not to adopt the more liberal rules on withdrawals, while all those from larger companies, with thousands of employees, did so.
In all cases, I had conversations with them about the potential benefits and negative consequences. No one really knew for sure what the future would be like immediately after the CARES Act was passed, so many clients chose to be safe and adopt the more liberal withdrawal provisions right away. Others, realizing that they could adopt CARES Act provisions at a future date if the situation warranted, chose to wait.
As it turned out, there were many businesses and industries that were not impacted at all by what happened in 2020. In fact, some of my clients have reported that 2020 was their best year ever. Other businesses and industries got hit pretty hard, of course. Those businesses that were hard hit, where you may have thought withdrawals may be the highest, turned out to have very few. The main reason was that these companies ended up laying people off, making them eligible to take total distributions of their 401(k) accounts, rather than withdrawals.
PLANADVISER: What do you make of the overall volume of withdrawal activity that we ended up seeing in 2020 and early 2021? In the end, the volume wasn’t as bad as some feared, but there has certainly been some damage done to retirement security, no?
Lawton: My larger clients, all of whom implemented the more liberal withdrawal policies, were split in terms of volume. Some saw very little change in the amount of withdrawals taken, while others experienced an extraordinary amount of withdrawals—up to 10 times pre-COVID-19 levels.
As it turned out, 2020 was a bad year to withdraw money from any investment. U.S. and overseas stock markets were up strongly during the year, which meant that those who withdrew funds early on missed out on a lot of earnings.
In my view, it is not likely that anyone will pay the amounts they withdrew back. That money has probably been spent. So those who have taken withdrawals suffered a double hit in 2020. They permanently withdrew some (or all) of their retirement balance and missed out on earning some very good returns on those balances.
PLANADVISER: Have you seen any evidence that plan participants who took CRDs are putting serious thought into how this might impact their taxes in 2021 or subsequent years?
Lawton: No, none. I am afraid there will be quite a few people who have negative surprises when they complete their tax returns. For the average person, at first blush, the tax treatment of these withdrawals can seem very favorable. There is no 10% penalty tax and no 20% withholding requirement, and the tax liability can be spread over three years. And, again, there is the option pay back what you withdrew and get a refund of taxes paid.
So, if participants had a conversation with a tax expert before they took a withdrawal, they could have received the impression that taxes weren’t anything to worry about. This may have implied, to many people, that they wouldn’t have to pay any taxes on these withdrawals, which is not true.
PLANADVISER: Have you seen any indication that plan sponsors and/or recordkeepers are creating the infrastructure that will allow people to pay CRD funds back into their qualified accounts, allowing them to avoid the income taxation?
Lawton: Nope. I don’t think anyone believes that most people will be paying these withdrawals back.
PLANADVISER: You mentioned last year that participants who attempt to avoid bankruptcy by taking COVID-19 withdrawals and end up declaring bankruptcy anyway did not have to lose their retirement money. Can you explain again what you meant, i.e., that funds held in qualified retirement plans are not subject to bankruptcy proceedings? Should this be a part of plan sponsors’ or advisers’ messaging to participants as the pandemic drags on?
Lawton: This is an important point for all retirement plan participants to keep in mind. If you have money in a qualified retirement plan—such as a 401(k) plan—and you feel you may end up declaring bankruptcy, please don’t take a withdrawal from your plan to pay off debts in an attempt to avoid bankruptcy.
Bill collectors may be encouraging you to do this; however, your qualified retirement plan assets are not subject to attachment by creditors in a bankruptcy proceeding. In other words, your 401(k) balance cannot be taken away from you if you declare bankruptcy.
It would be great if all plan sponsors would discuss this point during their employee education sessions. I think it is also important that every employee who requests a hardship withdrawal receive an automatic referral to the company’s EAP, or employee assistance program, for financial counseling. Counseling should be completed prior to the withdrawal being approved and processed.
Many employees lose everything in a bankruptcy because they aren’t aware of the protections they are afforded. Getting them financial counseling as early as possible helps them not only get back on their feet quicker, but it can help preserve their self-esteem. Application for a hardship withdrawal is one of the early warning indicators of financial trouble.
PLANADVISER: What are your broad thoughts about how the industry has navigated the COVID-19 pandemic? Have sponsors and participants gotten the advice and guidance they need? Where have some of the pain points been, in your view, and what has gone well?
Lawton: I think the federal government responded admirably to the COVID-19 crisis by providing flexibility to employees with regard to their retirement plan balances in a very timely way. This is unusual in that the federal government can be a stumbling block.
I have observed plan sponsors responding appropriately for their corporate culture in taking advantage of the CARES Act provisions that work best in their environments. I haven’t seen employers struggling with the benefit implications of the COVID-19 crisis as much as the staffing and quarantining issues.
From my point of view, the federal government did an excellent job providing employers the flexibility they needed regarding retirement benefits in a time of crisis, and employers did a super job of using what worked best in their businesses.