PLANADVISER regularly receives emailed questions and comments from its readership, on topics ranging from stock market projections and plan design to matters of recordkeeping and compliance.
Recently, a reader submitted what is a timely and important question about the section of the Coronavirus Aid, Relief and Economic Security (CARES) Act that eases the rules and penalties restricting early withdrawals from defined contribution (DC) retirement plans. In short, the law created a new emergency retirement plan distribution option dubbed the “coronavirus-related distribution,” or “CRD” for short.
Under the CARES Act, a CRD can be drawn from an employer sponsored retirement plan, such as a 401(k), or from individual retirement accounts (IRAs) in any amount up to $100,000. The normal 10% penalty tax levied on early plan distributions by the Internal Revenue Service (IRS) is waived for CRDs and, furthermore, the individual taking a CRD can spread the reported income over three years for tax purposes. The distribution also can be repaid within three years to avoid taxation.
Critically, the law stipulates that CRDs are meant only for those people who have been diagnosed with COVID-19, have cared for a family member who got COVID-19, or have lost their job or otherwise suffered direct and serious financial harm as a result of the pandemic. As the law is written, it appears to allow individuals to self-certify that they qualify for a CRD, and it doesn’t require retirement plans to collect and/or retain records of such self-certifications—though many diligent plan sponsors are expected to do such tracking and recordkeeping.
This is where the reader’s comments and question come in: “I am aware of ineligible people using the coronavirus hardship withdrawal. Some are withdrawing $10,000 to $50,000 but are not affected financially, nor have they had the virus. In fact, they are working more now and are receiving overtime pay. What will be the repercussion if or when they have to show proof of a hardship and cannot?”
We put that question to several expert attorneys, and they agreed universally that such a participant faces significant potential risk, given that they are essentially committing fraud. In all frankness, though, they agreed it is far from clear that the IRS will at some point choose to focus its limited resources on policing this issue.
“Still,” one attorney explains, “the plan administrator may, but is not required to, obtain certification from the plan participant that they have suffered the necessary hardship. Down the line, if IRS discovers the issue on audit, the participant can be subject to substantial penalties.”
Robert Lawton, president of Lawton Retirement Plan Consultants, makes the case in a commentary that plan sponsors should actually refrain from permitting such hardship withdrawals. As Lawton emphasizes, the CARES Act does not require plans to make this relief available. Thus, if a plan sponsor has a strong conviction that their plan population has not greatly suffered financial harm as a direct result of the pandemic, the prudent course of action is to refrain from permitting this new type of penalty-free hardship withdrawal.
“You should know that the CARES Act does not require participants who take these withdrawals to show evidence of financial hardship or loss, as would be required under normal hardship withdrawal provisions,” Lawton says. “The CARES Act restricts COVID-19 withdrawals to plan participants who have been diagnosed with COVID-19; who have a spouse or dependent who has been diagnosed with COVID-19; who have experienced adverse financial consequences as a result of being quarantined, furloughed or laid off or having their work hours reduced; or who have been unable to work because of a lack of child care due to COVID-19.”
Lawton argues these CARES Act withdrawal provisions were enacted with good intentions.
“However, taking advantage of them will generally not be in most participants’ best interest,” he says, citing a long list of factors beyond the risk of fraud. First, even though participants have the option of paying these withdrawals back, the vast majority won’t. Second, Lawton says, a significant number of participants who withdraw up to $100,000 from their retirement plan accounts will destroy their chances of retiring with a sufficient balance. And finally, Lawton adds, the bankruptcy protections afforded to retirement plan assets should be considered.
“The potential that a participant may have to declare bankruptcy is critical when considering these withdrawals,” he says. “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. Funds held in qualified retirement plans are not subject to bankruptcy proceedings. Most participants are unaware that they can declare bankruptcy and protect their retirement savings. Losing all of their personal and retirement savings at the same time will financially destroy many families. And it does not have to happen because retirement savings are protected.”
Lawton further cites the likelihood that shares will be sold at a loss and the fact that enhanced unemployment compensation is available in many states.
“If you feel you need to provide greater employee access to plan balances, and your plan permits loans, consider adopting the relaxed CARES Act loan provisions instead of the withdrawal provisions,” Lawton advises. “While I normally don’t favor 401(k) loans, they are a better option than withdrawals during this pandemic.”