Accessing Retirement Assets Under CARES Act
The CARES Act provides relief for workers to tap retirement assets for short-term needs. However, investors must be cautious.
The CARES Act provides relief for workers to tap retirement assets to support short-term financial needs triggered by the COVID-19 health crisis. The options of expanded loans and increased hardship distributions could serve as helpful buffers against the recent economic shocks. However, these options should be taken with caution as they can jeopardize retirement readiness.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law on March 27, 2020. The act aims to contain the economic impacts of COVID-19 and provide assistance for U.S. workers, families, and small businesses.
There are three key provisions to provide short-term relief for retirement investors. Specifically, the provisions are:
- To waive the required minimum distribution in 2020 from qualified retirement
- To waive the 10% tax penalty on taking early distributions before age 59½ and allow distributions up to $100,000 or 100% of the vested account value for those qualified
- To double the loan limits to $100,000 or 100% of the vested account balance and extend repayment periods in qualified
“The coronavirus-related distributions will still be subject to regular income tax, but can be treated as equal withdrawals over a three year period beginning with the tax year 2020.”
The required minimum distribution suspension helps avoid withdrawals required based on values which were determined as a percentage of account balance as of December 31, 2019 that were much higher than current balances given the recent market downturn.
For clarification, the coronavirus-related distributions will still be subject to regular income tax, but can be treated as equal withdrawals over a three year period beginning with the tax year 2020.
The act also allows investors to recontribute the withdrawals back to an eligible retirement plan, in a single or multiple payments, within three years. The re-contributions will not count toward the maximum deferral limits. New contributions can still be made to the plans, subject to the ongoing Internal Revenue Service limits.
Plan sponsors generally need to amend their plan provisions in order to implement the CARES-authorized changes relating to loans and distributions. While still awaiting further clarity and guidance from federal agencies, a number of plan sponsors are already weighing the options or taking action.
According to a recent survey, about 32% of plans would double their loan limits, with larger plans more likely to do so. Nearly half of the plans would allow coronavirus-related distributions of up to $100,000 or 100% of vested balance, which could be repaid during the next three years.1
“While still awaiting further clarity and guidance from federal agencies, a number of plan sponsors are already weighing the options or taking action.”
Altruistic plan sponsors who release resources to help their participants may also be concerned about an exodus of savings. They may wonder if the participants’ urgent needs would erode their longer term commitment to retirement preparation. For reference, on average over the past 20 years, roughly one-fifth of 401(k) participants with access to loans had loans outstanding. During the 2008 financial crisis, the percentage of participants who were borrowing and the ratio of loan to account balance only ticked up slightly.2
How would a worker’s retirement readiness be affected if she opted for one of the options versus another, as permitted under the CARES Act? Let’s run some quick analysis for a representative worker and see what the potential impact might be on their retirement portfolio.
When the worker saves regularly, including employer matching contributions, and invests in a portfolio with a moderate expectation of investment returns, she could accumulate around $1.2 million upon retirement. If the COVID-19 health crisis tightens her budget significantly, she could stop contributing for three years. That could lead to an almost 9% loss in their retirement wealth.
“This analysis reveals that no matter which option a worker pursues, the savings leakage would be significant. A hardship withdrawal without any replenishment, which could be absolutely necessary to support self or family, would most significantly undermine the retirement prospect.”
If the worker chose to borrow a loan of $100,000, as allowed by the amended plan provisions, and then repay it back to herself, she would fare slightly better. This is because of interest payment being credited to her account.
If she took a one-time hardship withdrawal of $100,000, the lost opportunity cost for wealth accumulation would be 38%. As stated earlier, this “coronavirus-related distribution” would not be charged the 10% penalty but still be subject to income tax. The withdrawal would thus not be able to support spending in its entirety (factoring in a 20% tax rate, for instance). And finally, if the worker managed to replace the withdrawal in three installments, she could mitigate the wealth loss to around 10%. In this case, no interest charge would be involved and the income tax paid would be refunded.
Estimated wealth loss (%) at age 36
Estimated wealth loss (%) at age 46
Estimated wealth loss (%) at age 56
Stop contribution for 3 years
Loan and repay in 3 years
Distribution with no recontribution
Distribution with recontribution in 3 years
Source: Northern Trust Asset Management. Assumptions for a representative worker: a salary of $50,000 at age 25, pay raise 2.5% yearly until retirement at age 65, contribute 6% of pay, escalate by 1% annually to 10% of pay, employer matching contribution of 50% and up to 6% of pay, 5% constant investment return and 4.25% interest rate on loans. With the above assumptions, the worker’s account balance is just above $100,000 at age 36.
This analysis reveals that no matter which option a worker pursues, the savings leakage would be significant. A hardship withdrawal without any replenishment, which could be absolutely necessary to support self or family, would most significantly undermine the retirement prospect.
Loans and withdrawals could occur at any age. For those older workers, borrowing or withdrawing the same amount of $100,000 would lead to smaller but still significant wealth losses. Such loans or withdrawals are smaller relative to the account balance at the older age and the forgone investment returns are also over a shorter time horizon before retirement.
For clarity, a “coronavirus-related distribution” can be made in 2020 from a plan to a “qualified individual” including:
- A person who is diagnosed with COVID-19; whose spouse or a dependent is diagnosed with COVID-19.
- A person who experiences adverse financial consequences because of corona- virus-related situations such as quarantine, termination, furlough, reduction in hours, or staying home to care for
- A person who experiences adverse financial consequences due to the closing or reducing hours of a business owned or operated by the individual because of the
Plan administrators rely on an employees’ self-certification that they meet one of these coronavirus-related situations to approve the distribution.
The CARES Act is designed to help people afford to live through this difficult time amidst the COVID-19 pandemic. The provisions loosen restrictions on resources for those who are struggling. Nonetheless, the elevated ease of obtaining larger loans or withdrawals contradicts the long standing view that retirement assets should not be tapped until retirement. Hardship withdrawals without recontributions, in particular, damage the financial prospect for retirement. As such, these distribution options should be used as a last resort after all other avenues have been explored.
1 Plan Sponsor Council of America (PSCA), 2020, “How Are Plan Sponsors Responding to the COVID-19 Pandemic?”
2 Jack VanDerhei, Sarah Holden, Luis Alonso, and Steven Bass. “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2015.” EBRI Issue Brief, no. 426, and ICI Research Perspective, Vol. 23, no. 6 (August 2017).
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Gaobo Pang, Ph.D., CFA
Director of Analytics, The Northern Trust Institute
Practice Lead, Retirement Solutions
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