The Effect of COVID-19 on Cash Flow
The COVID-19 pandemic is affecting the economy and cash flow issues for small business owners of all types, including dental practices. As a dentist, if you have a 401(k) plan at your practice and need some cash, you might be tempted to borrow or withdraw money from it. But keep in mind that the purpose of a 401(k) is to save for retirement. Take money out of it now, and you'll risk running out of money during retirement.
The good news: if you need to make a withdrawal, the federal CARES Act (Coronavirus Aid, Relief and Economic Security Act) temporarily loosens the rules on hardship distributions. Thus, if you are affected by the crisis, you may not face the usual 10% penalty for withdrawing up to $100,000 before age 59½.
The law also doubles the amount that 401(k) participants can take in loans from an account for the next six months to the lower of $100,000 or 100% of the account balance. IRAs don’t permit loans.
There are several other temporary changes to retirement plan rules that come into effect with the relief package legislation. Here are some of the highlights.
Your plan may allow for loans from participant accounts. This may be a better option than withdrawing money. Generally, obtaining a 401(k) loan is easy — there’s little paperwork, and there’s no credit check.
How much can you borrow?
No matter how much you have in your 401(k) plan, you probably won't be able to borrow the entire sum. Normally, you can’t borrow more than $50,000 or one-half of your vested plan benefits, whichever is less. (An exception applies if your account value is less than $20,000. In this case, you may be able to borrow up to $10,000, even if this is your entire balance.) The relief package has increased the maximum to $100,000 and increased the time allowed to pay back the loan.
What are the requirements for repaying the loan?
Typically, you have to repay money you've borrowed from your 401(k) within five years by making regular payments of principal and interest at least quarterly, often through payroll deduction. However, if you use the funds to purchase a primary residence, you may have a much longer period of time to repay the loan.
- If you don't repay your plan loan when required, it will generally be treated as a taxable distribution.
- If you’re an associate dentist or an employee of the practice and leave your employer's service (whether voluntarily or not) and still have an outstanding balance on a plan loan, you'll usually be required to repay the loan in full within 60 days. Otherwise, the outstanding balance will be treated as a taxable distribution, and you'll owe a 10% penalty tax in addition to regular income taxes if you’re under age 59½.
- Loan interest is generally not tax deductible (unless the loan is secured by your principal residence).
- You'll lose out on any tax-deferred interest that may have accrued on the borrowed funds had they remained in your 401(k).
- Loan payments are made with after-tax dollars.
Your 401(k) plan may have a provision that allows you to withdraw money from the plan if you can demonstrate “heavy and immediate” financial need and you have no other resources you can use to meet that need (e.g., you can’t borrow from a commercial lender or from a retirement account and you have no other available savings). Many plans allow hardship withdrawals only for the following reasons:
- To pay the medical expenses of you, your spouse, your children, your other dependents or your plan beneficiary.
- To pay the burial or funeral expenses of your parent, your spouse, your children, your other dependents or your plan beneficiary.
- To pay a maximum of 12 months’ worth of tuition and related educational expenses for post-secondary education for you, your spouse, your children, your other dependents or your plan beneficiary.
- To pay costs related to the purchase of your principal residence.
- To make payments to prevent eviction from or foreclosure on your principal residence.
- To pay expenses for the repair of damage to your principal residence after certain casualty losses.
Note: You may also be allowed to withdraw funds to pay income tax and/or penalties on the hardship withdrawal itself, if these are due.
In addition to the reasons stated above, the relief package will allow withdrawal of up to $100,000 without penalty for coronavirus-related need.
How much can you withdraw?
Generally, you can’t withdraw more than the total amount you’ve contributed to the plan, minus the amount of any previous hardship withdrawals you’ve made. In some cases, though, you may be able to withdraw the earnings on contributions you've made. Check with your plan administrator for more information on the rules that apply to withdrawals from your 401(k) plan.
What are the advantages of withdrawing money from your 401(k) in cases of hardship?
The option to take a hardship withdrawal can come in very handy if you really need money and you have no other assets to draw on, and your plan does not allow loans (or if you can't afford to make loan payments).
What are the disadvantages of withdrawing money from your 401(k) in cases of hardship?
- These withdrawals are normally used as a last resort. Taking a hardship withdrawal will reduce the size of your retirement nest egg, and the funds you withdraw will no longer grow tax deferred.
- Hardship withdrawals are generally subject to federal (and possibly state) income tax. A 10% federal penalty tax may also apply if you're under age 59½. As mentioned above, the penalty tax may be lifted for COVID-19-related withdrawal. (If you make a hardship withdrawal of your Roth 401(k) contributions, only the portion of the withdrawal representing earnings will be subject to tax and penalties.)
- You may not be able to contribute to your 401(k) plan for six months following a hardship distribution.
Minimum distribution waiver related to the relief package
The relief package will allow for a waiver of minimum distribution for 2020. This will allow individuals taking minimum distributions to waive liquidating assets at low share value caused by the virus-related stock market losses.
Before taking any action
It will now take some time to understand all the impacts to retirement plan rules, as well as time for plan administrators to make the necessary changes to accommodate the changes. Please work with your plan administrator, accountant and lawyer before taking any action.
For more information on the ADA Members Retirement Programs, consult with one of our retirement program specialists.
About the author
Mr. LoPorto is senior director and client relationship manager for the American Dental Association Members Retirement Program at AXA Equitable. With more than 25 years of experience in the retirement and financial services industry, he is responsible for supporting new business development, product development and relationship management and holds Series 6 and 26 registrations with the Financial Industry Regulatory Authority Inc. (FINRA).
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual's personal circumstances.
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