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Retirement

Q&A: What to do if an employer messes up your 401(k) coronavirus hardship withdrawal

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Dear Liz: I used the Coronavirus Aid, Relief, and Economic Security (CARES) Act to cash out my 401(k). My ex-employer waived the 10% penalty but withheld 20% for federal taxes. It seems unconscionable to keep $20,000 of my money for at least eight months instead of sending it to me. The law states I have three years to pay the taxes and I need that hard-earned money now. Is there anything I can do to make my former employer release my money?

Answer: Please contact your former employer immediately. It sounds like what you got was a regular distribution, which can be penalized as well as taxed and which can’t be paid back. Your employer can’t waive an IRS penalty — it either applies to the distribution by law or it doesn’t — and the 20% withholding indicates this was not a coronavirus hardship withdrawal, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting.

Coronavirus hardship withdrawals allow qualified people to withdraw as much as $100,000 of their balances from 401(k)s and IRAs, but these withdrawals aren’t available to everyone. You must have been affected physically or financially by the pandemic.

Plus, if you want to take the distribution from a 401(k), check if your employer is offering the option. A majority of employers now offer coronavirus hardship withdrawals, according to a Willis Towers Watson survey, but some are opting not to do so.

If you qualified for a coronavirus hardship withdrawal from a 401(k) plan offering that option, the distribution should not have been subject to withholding.

You would owe income taxes but not the usual 10% federal early withdrawal penalty, and you would have three years to pay the income taxes on the withdrawal. You also would have the option to pay the money back within three years and then amend your tax returns to get the taxes you paid refunded.

If your former employer did not offer coronavirus hardship withdrawals but you otherwise qualified, you had the option of rolling your 401(k) money into an IRA and then taking a coronavirus hardship withdrawal from the IRA. (You can typically roll money out of only a former employer’s plan. If you’re still working for that employer, such rollovers usually aren’t allowed.)

If your employer won’t release the withheld money, you still have a way to limit the damage. You can put the rest of what you received into an IRA, as long as you do so within 60 days, and then take a coronavirus hardship withdrawal from the IRA.

Unless you can come up with the $20,000 that was withheld, however, you’ll have to pay taxes and penalties on that $20,000 and you won’t be able to pay that money back. That’s unfortunate, but it’s better than having the entire $100,000 penalized and not having the option to pay any of it back.

Q&A: Withdrawing after-tax retirement funds

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Dear Liz: I have been contributing to retirement accounts for many years, starting back in the early 1980s. Back then, there were no deductions for contributions. I made about $50,000 of after-tax contributions, meaning I’ve already paid taxes on that money. Later I switched to before-tax contributions. Now that I am retired and approaching 65, in my feeble mind, I believe I should be able to withdraw that $50,000 without having to pay any taxes on it. However, things that I’ve read indicate that it may not be that easy. Can you help with this question, or at least point me in the right direction?

Answer: You will escape taxes on a portion of any withdrawal you make from a retirement plan that has after-tax money in it, said Mark Luscombe, principal analyst at Wolters Kluwer Tax & Accounting. However, only Roth IRAs allow you to make totally tax-free withdrawals of your contributions at any time.

With a Roth IRA, any withdrawals are considered first to be a return of contributions. For example, if you contributed $50,000 to an account that’s now worth $200,000, the first $50,000 you withdraw would be tax- and penalty-free, regardless of your age, Luscombe said. If you were under 59½, additional withdrawals could be subject to taxes and penalties.

With regular IRAs and 401(k)s, the tax treatment is different. Withdrawals are considered to be a proportionate return of your after-tax money, Luscombe said. If you contributed $50,000 after tax and then withdrew the same amount from an account now worth $200,000, only one quarter of the money would escape tax.

Q&A: Coronavirus aid law lets you more easily tap retirement savings. That doesn’t mean you should

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Dear Liz: You recently mentioned that a person can withdraw money from their 401(k) and spread the taxes over three years. If 401(k) is paid back, they can amend their tax returns to get those taxes refunded. Because of some major home repairs, I asked our accountant about this before we proceeded. He said that he hasn’t read anything official about the above. Would you please provide where you obtained your information, so we can decide if that’s an avenue we can use?

Answer: It’s possible you had this conversation before March 27, when the Coronavirus Aid, Relief, and Economic Security (CARES) Act became law.

Otherwise, it’s kind of hard to imagine an accountant anywhere in the U.S. who hasn’t heard of the emergency relief package that created the stimulus checks being sent to most Americans, as well as the Paycheck Protection Program’s forgivable loans for businesses and the new coronavirus hardship withdrawal rules for 401(k)s and IRAs.

Those rules allow people who have been affected financially or physically by COVID-19, the disease caused by the novel coronavirus, to get emergency access to their retirement funds if their employers allow it.

Even if you do have access to such a withdrawal, you should consider other avenues first.

The income taxes on retirement plan withdrawals can be substantial, even when spread over three years. Perhaps more importantly, you probably would lose out on future tax-deferred returns that money could have earned because few people who make such withdrawals will be able to pay the money back.

A home equity loan or line of credit is typically a much better option for home repairs, if you can arrange it.

Q&A: Here’s why taking money from retirement accounts to pay bills is dumb

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Dear Liz: I do not qualify for a coronavirus hardship withdrawal, but I have debt on several credit cards with interest rates above 23%. In 2019, I paid nearly $2,500 in interest charges. I would like to remove $10,000 from my IRA and use it to pay off the debt. I would then put the money that would normally go toward the credit card debt ($500 a month) to pay back the IRA. Would this repayment mitigate some of my tax charges from the withdrawal, and how long do I have to replace the funds, if any?

Answer: Coronavirus hardship withdrawals are available to a large group of people, including those who have lost their jobs or suffered other financial setbacks because of the pandemic, as well as people actually diagnosed with COVID-19, the disease caused by the novel coronavirus.

Coronavirus hardship withdrawals allow people to take out up to $100,000 from individual retirement accounts or 401(k)s without paying early withdrawal penalties or facing mandatory withholding. Income taxes must be paid on the withdrawal, but that bill can be spread over three years.

People who take such withdrawals would have the option of putting the money back within three years. If they can repay the money, they could amend their previous tax returns to get a refund of the taxes they paid on them.

If you don’t qualify for a coronavirus hardship withdrawal, then the rules on taking money from your IRA haven’t changed. You cannot take a loan from an IRA, and any money you withdrew would have to be returned to a qualifying retirement account within 60 days or it’s considered a withdrawal.

You would have to pay income taxes on the withdrawal, plus the 10% federal penalty if you’re under 59½. Most states also tax and penalize such withdrawals.

Even if you could qualify for a coronavirus hardship withdrawal, though, it would be a bad idea to raid your retirement account to pay credit card bills.

Not only is the tax cost high, but you’re also losing the future tax-deferred returns that money could have earned. A $10,000 withdrawal now could mean $100,000 less in retirement funds 30 years from now.

Also, you shouldn’t use an asset that would be protected from creditors to pay debts that could otherwise be erased in case you have to file for bankruptcy.

Too many people drain their 401(k)s and IRAs trying to pay their bills, only to find out too late that their retirement accounts are protected in bankruptcy. Meanwhile, the bills — including credit card balances, medical bills and most other unsecured debts — could have been wiped out.

If you can make your credit card payments but want to reduce your interest costs, you could consider a personal loan to consolidate your debt if your credit is good. If your credit is not good or you are struggling financially, you could contact a credit counselor about a debt management plan that would allow you to pay off your cards over time at lower rates.

You can get referrals from the National Foundation for Credit Counseling.

Another option for people struggling to pay off their credit card debt is to ask the issuers about hardship programs. Many are willing to offer forbearance, which allows cardholders to skip payments, or to temporarily reduce required payments.

If you’re struggling, though, you also should make an appointment with a bankruptcy attorney about your options. You can get referrals from the National Assn. of Consumer Bankruptcy Attorneys.

Q&A: Volatile markets and retirement

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Dear Liz: With the tumult in the stock market, I’ve been thinking of a strategy which may be safe but not prudent. I have about $315,000 in a trust account which pays me about $9,000 a year in dividends. I’m 81. If I sell all the stocks in my trust account, I could draw the same $9,000 for over 10 years, not counting about 2% growth on the $315,000. What are your thoughts?

Answer: Many people have discovered they’re not as risk tolerant as they thought they were. The volatile stock market has unnerved even seasoned retirement investors. Most, however, should continue investing because they won’t need the money for decades, and even retirees typically need the kinds of returns that only stocks can deliver long term.

There’s no reason to take more risk than necessary, however. If all you need from your trust account is $9,000 a year, you’d be unlikely to run out even if your money is sitting in cash. But you may need more than $9,000 in the future — to adjust for inflation, for example, or to cover long-term care costs.

One option to consider is a single-premium immediate annuity. In exchange for a lump sum, you’d get a guaranteed stream of monthly checks for the rest of your life. At your age, you could get $9,000 a year by investing about $100,000 in such an annuity. Because your payments would be guaranteed by the annuity, you might be more comfortable leaving at least some of the rest of your account in stocks for potential growth.

Q&A: Reducing taxes in retirement

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Dear Liz: I agree with this concept of delaying Social Security to lessen overall taxes and have a further suggestion. My spouse and I are gradually converting our traditional IRA account funds to Roth IRAs. The converted funds are immediately taxable but could continue to gain in value and future distributions would not be taxable. Also, Roth accounts don’t have required minimum distributions.

Answer: Conversions make the most sense when you expect to be in the same or higher tax bracket in retirement.

That’s not the case for most people because they’re in a lower tax bracket when they stop working. Some older people, however, do face higher tax rates in retirement — typically because they’ve been good savers, and required minimum distributions from their retirement accounts will push their tax rates higher.

When that’s the case, they may be able to take advantage of their current lower tax rate to do a series of Roth conversions.

The math can be tricky, though, so it’s advisable to get help from a tax pro or financial planner. You don’t want to convert too much and push yourself into a higher tax bracket, or trigger higher Medicare premiums.

If your intention is to leave retirement money to your heirs, Roth conversions may also make sense now that Congress has eliminated the stretch IRA.

Stretch IRAs used to allow non-spouse beneficiaries — often children and grandchildren — to take money out of an inherited IRA gradually over their lifetimes. This spread out the tax bill and allowed the funds to continue growing. Now inherited IRAs typically have to be drained within 10 years if the inheritor is not a spouse.

To compensate, some people are converting IRAs to Roths — essentially paying the tax bill now, so their heirs won’t have to do so later. Heirs would still have to withdraw all the money in an inherited Roth IRA within 10 years, but taxes would not be owed.