In a previous post, we covered the impact of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) on employee welfare benefit plans, programs, and arrangements. This post explains how this new law affects tax-qualified 401(k) and other defined contribution plans.
In enacting rules governing distributions from tax-qualified retirement plans, Congress has historically sought to strike a balance between encouraging retirement savings while at the same time recognizing that there are instances in which participants may have legitimate reasons to access funds before they retire. Participant loans, hardship distributions, and certain limited purpose in-service distributions all allow participants to access funds in their retirement accounts while they are still working. The CARES Act contains several provisions that enable plan sponsors to provide plan participants with access to funds in defined contribution retirement plans and individual retirement accounts (“IRAs”) to pay for unanticipated costs associated with the coronavirus pandemic.
Under existing law, distributions from tax-qualified retirement plans, tax-sheltered annuity 403(b) plans, governmental deferred compensation 457(b) plans, and IRAs are generally includible in an individual’s gross income in the year of the distribution. Distributions may however be rolled over tax-free in an eligible rollover distribution with certain exceptions. (An “eligible rollover distribution” is a distribution from one tax-qualified retirement plan to another tax-qualified retirement plan or IRA). Exceptions include substantially equal periodic payments over a specified period of at least 10 years, or for the life or the life expectancy of the employee (or the employee and the employee’s designated beneficiary); minimum required distributions; and hardship distributions.
If an eligible rollover distribution is made directly to another tax-qualified retirement plan or IRA, (i.e., in a trustee-to-trustee transfer), no taxes are withheld. Where an individual receives a distribution other than in a direct rollover, however—for example, by check or direct deposit to the individual’s personal account—20% of the distribution must be withheld. The distribution is taxed as ordinary income unless the amount is re-contributed to a tax-qualified retirement plan or IRA within 60 days. If the amount is transferred within 60 days, the individual is permitted to rollover the full amount of the eligible rollover distribution using funds from other sources to make up for the shortfall.
Where taxable distributions are made from a plan before certain distributable events, the distribution is subject to an additional tax of 10% of the portion of the distribution that is includible in income. This tax is increased to 25% in the case of certain SIMPLE IRA distributions. This tax does not apply, however, to: (i) distributions made on or after the employee attains age 59 ½; (ii) distributions made to a beneficiary on or after the employee’s death; (ii) distributions made because of the employee’s disability; and (iv) distributions that are a part of substantially equal periodic payments made over the employee’s life or life expectancy.
Although profit sharing plans can permit in-service distributions where contributions have been in the plan for at least two years, or an employee has been a participant in the plan for at least five years, these provisions are not common.
Elective deferrals, qualified nonelective contributions, and qualified matching contributions under a 401(k) plan may not be distributed to participants or beneficiaries earlier than severance from employment, death or disability, plan termination, or attainment of age 59 ½. Participants may also be permitted to withdraw their elective contributions, QNECs, and QMACs, and earnings thereon in the event of hardship. Similar rules apply to 403(b) plans and governmental 457(b) plans. Hardship withdrawals are subject to income tax and, for participants under the age of 59 ½, are also subject to a 10 percent early withdrawal penalty.
Section 2202 of the CARES Act adds a new distribution option, referred to as a “COVID-19-Related Distribution.” A COVID-19-Related Distribution is a distribution to a “qualified individual” from an eligible retirement plan (i.e., a tax-qualified retirement plan, 457(b) plan of a governmental employer, or IRA) on or after January 1, 2020 and before December 31, 2020, that exceeds $100,000 taking into account all such distributions for the employee’s taxable year. A “qualified individual” is an individual—
(i) Who was diagnosed with the virus by a test approved by the CDC;
(ii) Whose spouse or dependent is diagnosed with the virus or disease; or
(iii) Who experiences adverse financial consequences as a result of being quarantined, being furloughed or laid off, or having work hours reduced due to such virus or disease; being unable to work due to lack of child care due to the virus or disease; closing or reducing hours of a business owned or operated by the individual due to such virus or disease; or other factors as determined by regulation.
Qualified individuals may elect to include COVID-19-Related Distributions in income ratably over the three-year period beginning with the taxable year in which the first such distribution is made. These individuals have up to three years beginning on the day after the distribution was received to repay the distribution by making one or more “coronavirus repayments” to any eligible retirement plan (such as an IRA or qualified plan). Repayments are treated as eligible rollover distributions subject to the rules that govern rollovers generally.
The 10 percent additional income tax on amounts received by an individual as an early distribution from a qualified retirement plan is waived in the case of a COVID-19-Related Distribution. If a distribution qualifies as a COVID-19-Related Distribution, the plan administrator does not have to provide a § 402(f) notice. Nor is the plan administrator (or other payor) required to withhold an amount equal to 20% of the distribution, as is usually required by tax withholding rules. The distribution is, however, subject to voluntary withholding.
Plan administrators may rely on employees’ certifications as proof that they qualify for a COVID-19-Related Distribution.
Under existing law, defined contribution plans, including 401(k) plans, may allow participant loans subject to certain limits. The maximum loan amount is generally capped at the lesser of half of the participant’s vested account balance or $50,000. Loans must be repaid in level installments over five years in substantially level payments over the term of the loan with payments no less frequently than quarterly. The term of the loan may be longer if the loan proceeds are used for the purchase or construction of a principal residence.
Section 2202(b) of the CARES Act modifies the plan loan rules with respect to loans to a qualified individual made during the six-month period beginning March 27, 2020. The term “qualified individual” has generally the same meaning set forth above in connection with COVID-19-Related Distributions. During that period, the $50,000 upper limit is increased to the lesser of 100 percent of the qualified individual’s vested account balance under the plan or $100,000. Furthermore, if the due date for the repayment of a plan loan made to a qualified individual falls within the six-month period beginning on March 27, 2020, the repayment date is delayed for a full year.
The loan repayment date of any loan payment due before January 1, 2021 owed by a qualified individual with an outstanding plan loan is delayed for one year. Subsequent payments must be adjusted for accrued interest. The delay does not modify the five-year maximum loan amortization period.
Temporary Waiver of RMDs
To ensure that tax-qualified retirement plans and IRAs are used for retirement income and not as vehicles for long-term wealth accumulation, Congress has decreed that participants and IRA account holders must generally begin taking taxable withdrawals—so-called required minimum distributions or “RMDs”—as of a designated date. Until recently, in the case of a participant in a tax-qualified retirement plan, RMDs were required to commence by April 1 of the calendar year following the year in which the participant attains age 70 ½ or the year in which the participant retires, if later. For a 5% owner of a business that sponsors the retirement plan or an IRA account holder, the RMD date was April 1 following the calendar year in which the owner or account holder attains age 70 ½. The minimum amount that must be distributed is calculated by dividing the account balance on December 31 of the year preceding the distribution by the participant’s or IRA owner’s life expectancy. RMDs must be received by December 31 of each year. Failure to take the required minimum distribution results in a 50% excise tax on the amount not distributed as required. The SECURE Act, which was signed into law December 20, 2019, raised the age for beginning RMDs to 72 in the case of individuals who attain age 70 ½ after December 31, 2019.
CARES Act Section 2203 temporarily waives RMD requirements for calendar year 2020. The waiver applies to tax-qualified plans, 403(a) and 403(b) plans, governmental 457(b) plans, and IRAs. It is not available to participants in defined benefit plans, including cash balance plans. The temporary waiver is available to all individuals irrespective of whether they are affected by COVID-19. For RMDs commencing in 2020 (i.e., in the case of a participant who turned 70 ½ in 2019 and who has not yet taken an RMD), both RMD payments are waived. The participant will commence taking RMDs in 2021.
Individuals who have already taken their RMD for 2020 do not qualify for relief, but the individual may use the 60-day rollover rule to redeposit the RMD back into a retirement plan solution. (IRS Notice 2020-23 extended the 60-day period for RMDs made between Feb. 1, 2020 and May 15, 2020 until July 15, 2020.) This option is not available to non-spouse beneficiaries of IRAs for whom rollovers are not allowed. Distributions from inherited IRAs are disregarded in calendar year 2020 when determining the period over which distributions must be made, however. Thus, a non-spouse beneficiary of an inherited IRA who would ordinarily be required to take taxable distributions within five years of the death of the owner now has six years to do so.
Defined contribution plans, including 401(k) plans, may but are not required to allow for distributions on account of hardship. Plans that allow for hardship distributions must specify which situations qualify as such. A hardship distribution must be made on the immediate and heavy financial need of a plan participant, or the spouse or dependent of a participant, and the amount of the distribution must be necessary to satisfy that need. Whether a need is immediate and heavy depends on the facts and circumstances. Certain expenses are deemed to be immediate and heavy, including expenses and losses due to a disaster declared under the Robert T. Stafford Disaster Relief and Emergency Assistance Act, provided that the employee’s principal residence or principal place of employment at the time of the disaster was located in an area declared by the Federal Emergency Management Agency (“FEMA”) as a disaster area. FEMA has made such declarations only with respect to selected states and localities.
While the CARES Act does not modify the rules governing hardship distributions, it appears that hardship distributions might be able to qualify as COVID-19-Related Distributions. Thus, if a participant takes a hardship distribution, and if the distribution also meets the requirements of a COVID-19-Related Distribution, the participant should be able to quality for the special tax treatment afforded COVID-19-Related Distributions. This is an issue that will likely be addressed in future guidance.
Plan sponsors can defer the adoption of plan amendments reflecting the implementation of the CARES Act relief until the last day of the first plan year beginning on or after January 1, 2022 (i.e., December 31, 2022 for calendar year plans). The IRS will be issuing guidance relating to plan amendments. In the meantime, plans will not be treated as failing to operate in accordance with their terms by virtue of taking advantage of relief afforded by the CARES Act.