5 ways the CARES Act impacts retirement planning
In response to the halting U.S. economy, set off by the coronavirus pandemic, the federal government has passed a massive emergency funding bill to protect and support American businesses, hospitals and individuals. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) is a far-reaching bill with over 1,000 pages of text that detail the funding, loans, and tax provisions designed to provide economic relief.
The CARES Act also includes changes that will impact retirees’ retirement income strategies, including how they use their IRAs, 401(k)s, Social Security.
The five main areas of retirement planning impacted by the CARES Act are: required minimum distributions, 401(k) loans, Social Security benefits, the new coronavirus-related distribution exception, and charitable giving. Let’s dive into each of these areas.
1. Required Minimum Distributions
What changed: Perhaps the biggest retirement-related change the CARES Act made was suspending all required minimum distributions (RMDs) from retirement accounts for 2020. These accounts include 401(k)s, inherited retirement accounts, 403(b)s and 457(b)s.
The provision is very broad and is not a push off to 2021 – you will not have to take two RMDs next year. In essence, you do not owe any RMDs for 2020, inherited or otherwise.
The impact: The biggest impact from waiving RMDs for 2020 is that retirees can leave their retirement accounts alone for another year. With a lot of market volatility and uncertainty in the economy, many retirement accounts might have seen a decline in value during the start of the year after high balances at the end of 2019 (the time period RMDs would have been calculated on).
It can be a huge benefit to retirees if they leave their investments alone for a year and let them recover from the market downturn. They still have the flexibility to pull out as much money as they need from their retirement accounts in 2020, they just aren’t required to take out anything.
The 2020 RMDs suspension also makes doing Roth Conversions easier as retirees don’t need to take out their RMD before doing a conversion. With many retirees experiencing lower taxes due to the Tax Cuts and Jobs Act and the decline in the market, now could be an opportune time to do Roth Conversions.
2. 401(k) loans (and other defined contribution plans)
What changed: Many 401(k)s and other defined contribution plans allow participants to take out a plan loan of up to $50,000 or half of their own vested account balance. Typically, loans are then repaid over a five-year period through payroll deductions.
The CARES Act made two big changes as it relates to 401(k) loans.
First, plans now allow a participant to borrow up to 100% of his or her vested account balance or $100,000, whichever is less. These expanded limits only apply to loans made from March 27 to September 23, 2020. Also, remember that not all retirement plans allow for participant loans, it is a decision that is made at the individual plan level.
Second, the CARES Act gives people an extra year to pay back their loans if 2020 was one of the five years for their outstanding loan repayment, essentially creating a six year repayment period with no more payments due in 2020.
The impact: The 401(k) loan amounts expansion and delayed loan payment can provide relief in two meaningful ways.
Borrowing money from your 401(k) for short-term needs is not always ideal, but in a crisis – such as a worldwide pandemic – it can be a better strategy than taking out personal loans or credit card debt. The benefit of a 401(k) loan is that while you owe interest on the loan, it pays back into your own retirement account. You don’t have to pay someone else to borrow your money, you pay yourself to borrow money.
Loan funds are not taxable as ordinary income when they come out of the plan and can be repaid, whereas normal distributions are taxable and typically cannot be put back into the plan easily.
Second, granting individuals another year for 401(k) loan repayments means they don’t have to remove money from their paycheck. This allows for higher cash flow and paychecks for the rest of the year.
It’s a good idea to contact your employer and retirement plan provider to make sure you can push off your loan payment. It is unlikely most plans and employers will make the suspension of 2020 payments an automatic feature so it is up to the individual to request.
3. Social Security benefits
What changed: Social Security benefits are not directly impacted by the coronavirus pandemic. However, Section 2302 of the CARES Act allows self-employed individuals and employers to push off the employer-side liability of federal Social Security taxes owed on employee wages from March 27 through December 31, 2020.
Generally, employers and employees pay a 6.2% Social Security tax for FICA taxes with a wage base limit of $137,700 in 2020.
Those who are self-employed pay both the employer and employee-side of SECA taxes, so 12.4%. After the CARES Act, both the self-employed and employers can push off the employer payment of 6.2% until December 31, 2021 when 50% is owed. The remaining 50% is owed a year later, by December 31, 2022.
The impact: The coronavirus epidemic can put more pressure on the Social Security trusts funds, which are on pace to run out of money by 2033 or 2034 and would only be able to provide about 78% of promised benefits.
The push-off of FICA and SECA taxes would normally have a big impact on Social Security, but the CARES Act says the trust funds will be backfilled during this time by general revenue. However, with the potential of broad declines in revenue in 2020 and the increase in unemployment, fewer people might be paying into the trust funds.
If unemployment remains high for a few years, it could bring down the income into the trust funds and accelerate the trust depletion date.
A short-term economic slowdown and job loss won’t have a huge impact, but a prolonged period could have a significant impact. It will be important to watch how the epidemic and economic condition progress.
In the short term, Social Security benefits will remain in good shape and be paid out to all retirees as a paycheck they can continue to rely upon.
It’s also important to consider Social Security claiming strategies for those suffering under the current economic conditions. Many people over age 62 who wanted to delay Social Security, which can often be the best overall retirement income strategy to maximize long-term Social Security benefits, may want to consider claiming benefits sooner. If your investments are down significantly or you lost your job and need the money, it might make sense to claim Social Security benefits in 2020.
If your assets recover or you find a new job, you could repay your benefits within a year and go back into deferral. You can also voluntarily suspend your Social Security benefits at full retirement age and get the 8%-a-year increase if you defer. If you decide you need benefits earlier than you had planned, you have options to return to deferral in the future.
4. New coronavirus-related distribution exception
What changed: A coronavirus-related distribution is one that is made after January 1, 2020 and before December 31, 2020 for an individual or their spouse who is diagnosed with COVID-19 or if they experienced adverse financial consequences caused by the coronavirus, such as being laid off, having hours reduced, being quarantined or furloughed.
Up to $100,000 can be withdrawn from a retirement, exempt from the 10% penalty tax if the distribution is taken before age 59.5. A retirement plan can rely on a participant’s written statement that he or she meets the conditions.
The distribution will be automatically spread out over the next three years from a tax perspective. However, you can opt to treat the entire distribution as taxable in 2020.
This distribution can come from an IRA, which typically does not allow plan loans. You can repay the coronavirus-related distribution for up to three years after the day of distribution. The repayment would be treated as a rollover in 2020, so you might have to file an amended tax return for 2020 if you repay in a few years to get your taxes back.
The impact: For many people, this will open up a large distribution amount from IRAs, which usually don’t allow for loans. As people are laid off, experience decreased income due to the economic changes, or are otherwise financially impacted by the coronavirus, they can tap into their retirement accounts without penalty tax and repay it over a few years. The ability to repay the retirement funds is very important. You can use the funds for a short-term need, and you can repay it, so you don’t wipe out your long-term retirement funding.
5. Charitable giving
What changed: The CARES Act includes three major changes to charitable giving.
The first change relates back to RMD suspensions for 2020. You can still do a qualified charitable distribution (QCD) of up to $100,000 from your IRA to a qualified charity in 2020. The direct distribution to a charity would not show up as taxable income to the individual. However, since RMDs are suspended for 2020, the distribution won’t offset any RMDs.
Second, the CARES Act created a new above-the-line deduction of $300 for charitable contributions.
And third, the CARES Act allows for cash gifts to most public charities of up to 100% of adjusted gross income in 2020. This is normally limited to 60% of AGI.
The impact: Many retirees might choose to forgo giving via a QCD in 2020 if they wanted it to offset RMDs. Instead, you might decide to wait until 2021 to do a QCD when it will offset RMDs.
The new above-the-line $300 deduction for cash gifts cannot be given to donor-advised funds (DAFs) or supporting organizations (SOs). However, the new deduction allows those who do not itemize their tax deductions to benefit from a tax deduction of up to $300 per individual from donating cash to a charity. Less than 10% of Americans are expected to itemize in 2020, so this could benefit many givers.
Lastly, if you have a large taxable event in 2020, like the sale of a business, it could make sense to take advantage of the one-time higher AGI limit for cash gifts. While it is not advisable to do a 100% AGI gift for most people, you can plan on making a large gift to charity in the future to leverage the new 2020 limit.
The CARES Act is a relief act for Americans suffering from fallout related to the coronavirus pandemic. The bill provides payments to individuals, funds to businesses, tax relief for many, and impacts retirement planning in 2020 and beyond.
There’s a lot to consider when it comes to the CARES Act – and that also includes the bill’s impact on Medicare, Medicaid, and HSAs that also impact retirement planning. Given these extensive changes, details and potential complexities tied into the bill, it is a great time to contact your financial advisor and learn how your taxes and retirement situation might be impacted by the relief effort, tax bills and overall economic conditions.