Will My Social Security Benefits Be Taxed? – Annapolis and Towson Estate Planning

Money Talks News’ recent article entitled “These 13 States Tax Social Security Income” says the federal government can tax plenty of types of retirement income — including Social Security benefits.

The taxation does not necessarily stop with the federal government because there are a number of state governments that also expect a cut from your Social Security income. In fact, there are 13 states that tax Social Security benefits:

  • Colorado
  • Connecticut
  • Kansas
  • Minnesota
  • Missouri
  • Montana
  • Nebraska
  • New Mexico
  • North Dakota
  • Rhode Island
  • Utah
  • Vermont
  • West Virginia

Whether your Social Security retirement benefits are subject to federal income taxes is determined by your tax filing status and what the U.S. Social Security Administration calls your “combined income.” This is your wages and self-employment income, interest and dividends and other taxable income. If your benefits are subject to federal taxes, the federal government will tax up to 85% of your benefits.

States that tax Social Security benefits do so according to their own rules, which can vary from state to state and differ from the federal tax code. Therefore, even if your benefits are not subject to federal taxes, they could still be subject to state income taxes — or vice versa. It depends on how a state taxes income and whether it offers any tax breaks that apply to Social Security income.

For example, Connecticut offers some residents a full exemption from state income tax for benefits. These residents pay no taxes on Social Security income, if one of the following situations applies: (i) their federal filing status is single or married filing separately, and their federal adjusted gross income is less than $50,000; or (ii) their federal filing status is married filing jointly, head of household or qualifying widow/widower and their federal adjusted gross income is less than $60,000.

Reference: Money Talks News (Sep. 22, 2021) “These 13 States Tax Social Security Income”

 

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What Should Small Business Owners Know about Estate Planning? – Annapolis and Towson Estate Planning

Not having an estate plan can place business owners and entrepreneurs in jeopardy because they may face difficulties in keeping the business running, if they have to withdraw from the business at any point in time.

Legal Reader’s recent article entitled “What Small Business Owners Should Know about Doing Estate Planning” explains that estate planning is necessary to ensure business continuity. Think about who can take control when you are no longer around to have the business continue according to your wishes contained in your estate plan. An experienced estate planning attorney can help business owners create a comprehensive estate plan, so things do not become chaotic for their family in the event of premature death or any permanent disability. Consider these steps when it comes to good estate planning for business owners.

Create an estate plan if you have not got one. A will is designed to detail your wishes about how you want the business to run and the manner of sharing your property at your death. A power of attorney allows an entrusted individual to undertake your business transactions and manage your finances, if you are incapacitated by injury or illness. A healthcare directive permits a trusted agent to make medical decisions on your behalf when you cannot do so yourself.

Plan for taxes. Tax planning is a major component of estate planning. Our tax laws keep changing frequently, so you have to stay in constant touch with your attorney to develop strategies for decreasing your tax liability, as well as creating a strategy for minimizing inheritance/estate taxes.

Buy life and disability insurance. Small business owners should think about purchasing life insurance, so their families can have a source of income after their death.

Create a succession plan. In addition to estate planning, a business owner should have a succession plan that specifies exactly how your company, and your family will prepare for a transition of ownership. The purpose of a well thought out succession plan is to keep the business operating or to take steps to sell it. This plan also includes the organizational structure of the business in case of maintaining business continuity.

Finally, you should keep everyone impacted by your decisions apprised of your estate plan and your business succession plan.

Reference: Legal Reader (Aug. 26, 2021) “What Small Business Owners Should Know about Doing Estate Planning”

 

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Make the Most of a Roth IRA, Even If You’re Not Ultra-Wealthy – Annapolis and Towson Estate Planning

While it may seem like only the ultra-wealthy benefit from a Roth IRA, this retirement tool is an excellent tax shelter that anyone can use, reports CNBC.com in the recent article “The ultra-wealthy have made full use of Roth individual retirement accounts. Here’s how you can do the same.” One of PayPal’s founders, Peter Thiel, had $5 billion in a Roth IRA as of 2019, according to a ProPublica report. It said that he used a self-directed Roth account, which allows the owner to hold alternative assets, like shares in a private company or real estate that generally cannot be placed in a regular Roth.

Traditional 401(k) plans and IRAs offer a tax break, when contributions are made. Taxes are paid upon withdrawal, which is supposed to happen only after a certain age when you have retired. By contrast, the Roth versions of the 401(k) and IRA do not have the tax break up front—you have to pay taxes on the money or assets when making contributions—but there are no taxes paid upon withdrawal, and there are no required withdrawals, as there are with traditional IRAs and 401(k)s.

You pay income taxes on the money placed into the account, and then it grows tax free. You can take it out anytime, as long as the account has been owned for at least five years and you are age 59½ or older. Self-directed Roth IRAs permit tax-free growth and untaxed distributions plus investments can be made that are not available in regular Roth accounts.

Theil had private company shares in his self-directed Roth IRA, before PayPal was a publicly traded company. He benefited from both timing and savvy investment skills.

Self-directed IRAs are generally available only through specialized custodians. Brand-name financial companies do not offer them. The custodians that hold self-directed IRAs do not manage the account or police what investments are placed into the accounts, so you will need the advice of a tax-savvy estate planning attorney to be sure you are following the rules. Note that there can also be valuation issues. The value of alternative assets is not as clear as publicly traded securities. You will need to get the value right, so you do not break any tax laws. Once assets are in the account, you can sell them and use the proceeds to purchase other instruments in the account, all under the same tax-free Roth protection.

Even if you do not use a self-directed Roth IRA, the standard Roth IRA yields many benefits. We do not know what the future tax environment will be, but tax-free withdrawals in the future, combined with high-growth assets, make the Roth IRA a good choice for retirement nest eggs.

Reference: CNBC.com (June 24, 2021) “The ultra-wealthy have made full use of Roth individual retirement accounts. Here’s how you can do the same”

 

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Are Roth IRAs Smart for Estate Planning? – Annapolis and Towson Estate Planning

Think Advisor’s recent article entitled “Secure Act 2.0, Biden Tax Hike Plans Make Roth IRAs a Crucial Tool” says that Roth IRAs offer an great planning tool, and that the Secure Act 2.0 retirement bill (which is expected to pass) will create an even wider window for Roth IRA planning.

With President Biden’s proposed tax increases, it is wise to leverage Roth conversions and other strategies while tax rates are historically low—and the original Secure Act of 2019 made Roth IRAs particularly valuable for estate planning.

Roth Conversions and Low Tax Rates. Though tax rates for some individuals may increase under the Biden tax proposals, rates for 2021 are currently at historically low levels under the Tax Cuts and Jobs Act passed at the end of 2017. This makes Roth IRA conversions attractive. You will pay less in taxes on the conversion of the same amount than you would have prior to the 2017 tax overhaul. It can be smart to make a conversion in an amount that will let you “fill up” your current federal tax bracket.

Reduce Future RMDs. The money in a Roth IRA is not subject to RMDs. Money contributed to a Roth IRA directly and money contributed to a Roth 401(k) and later rolled over to a Roth IRA can be allowed to grow beyond age 72 (when RMDs are currently required to start). For those who do not need the money and who prefer not to pay the taxes on RMDs, Roth IRAs have this flexibility. No RMD requirement also lets the Roth account to continue to grow tax-free, so this money can be passed on to a spouse or other beneficiaries at your death.

The Securing a Strong Retirement Act, known as the Secure Act 2.0, would gradually raise the age for RMDs to start to 75 by 2032. The first step would be effective January 1, 2022, moving the starting age to 73. If passed, this provision would provide extra time for Roth conversions and Roth contributions to help retirees permanently avoid RMDs.

Tax Diversification. Roth IRAs provide tax diversification. For those with a significant amount of their retirement assets in traditional IRA and 401(k) accounts, this can be an important planning tool as you approach retirement. The ability to withdraw funds on a tax-free basis from your Roth IRA can help provide tax planning options in the face of an uncertain future regarding tax rates.

Estate Planning and the Secure Act. Roth IRAs have long been a super estate planning vehicle because there is no RMD requirement. This lets the Roth assets continue to grow tax-free for the account holder’s beneficiaries. Moreover, this tax-free status has taken on another dimension with the inherited IRA rules under the Setting Every Community Up for Retirement Enhancement (Secure) Act. The legislation eliminates the stretch IRA for inherited IRAs for most non-spousal beneficiaries. As a result, these beneficiaries have to withdraw the entire amount in an inherited IRA within 10 years of inheriting the account. Inherited Roth IRAs are also subject to the 10-year rule, but the withdrawals can be made tax-free by account beneficiaries, if the original account owner met the 5-year rule prior to his or her death. This makes a Roth IRA an ideal estate planning tool in situations where your beneficiaries are non-spouses who do not qualify as eligible designated beneficiaries.

Reference: Think Advisor (May 11, 2021) “Secure Act 2.0, Biden Tax Hike Plans Make Roth IRAs a Crucial Tool”

 

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What are the Big Tax Penalties to Avoid in Retirement? – Annapolis and Towson Estate Planning

Building and living off a nest egg can be a challenge. However, you can make the situation worse, if you encounter some important laws for retirement accounts.

Money Talks News’ recent article entitled “3 Tax Penalties That Can Ding Your Retirement Accounts” says make one wrong step and the federal government may want some explanations. Here are the three penalties to avoid at all costs, when contributing to or withdrawing from your retirement accounts.

Excess IRA Contribution Penalty. If you put too much away in an individual retirement account (IRA), it can cost you. The IRS says you can (i) contribute an amount of money that exceeds the applicable annual contribution limit for your IRA; or (ii) improperly roll over money into an IRA.

If you get a little too anxious to build a nest egg and make one of these mistakes, the IRS says that “excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA. The tax cannot be more than 6% of the combined value of all your IRAs as of the end of the tax year.”

The IRS has a remedy to address your mistake before any penalties are imposed. You must withdraw the excess contributions — and any income earned on those contributions — by the due date of your federal income tax return for that year.

Early Withdrawal Penalty. If you take your money out too soon from a retirement account, you will suffer another potentially costly mistake. If you withdraw money from your IRA before the age of 59½, you may be subject to paying income taxes on the money—plus an additional 10% penalty, according to the IRS. The IRS explains there are several scenarios in which you are permitted to take early IRA withdrawals without penalties, such as if you lose a job, where you can use your IRA early to pay for health insurance. The same penalties apply to early withdrawals from retirement plans like 401(k)s, although again, there are exceptions to the rule that allow you to make early withdrawals without penalty. However, note that the exceptions which let you make early retirement plan withdrawals without penalty sometimes differ from the exceptions that allow you to make early IRA withdrawals without penalty. The Coronavirus Aid, Relief, and Economic Security Act (CARES) Act of 2020 also created a one-time exception to the early-withdrawal penalty for both retirement plans and IRAs, due to the coronavirus pandemic. Therefore, coronavirus-related distributions of up to a total of $100,000 that were made in 2020 are exempt.

Missed RMD Penalty. Retirement plans are terrific because they generally let you defer paying taxes on your contributions and income gains for many years. However, at some point, the federal government will want its share of that cash. Taxpayers previously had to take required minimum distributions (RMDs) from most types of retirement accounts starting the year they turn 70½. However, the Secure Act of 2019 moved that age to 72. The consequences of failing to make RMDs still apply, and if you do not take your RMDs starting the year you turn 72, you face harsh penalties. The IRS says:

“If you do not take any distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required.”

It is important to understand that the RMD rules do not apply to Roth IRAs. You can leave money in your Roth IRA indefinitely, but another provision of the Secure Act means your heirs must be careful if they inherit your Roth IRA.

Reference: Money Talks News (Feb. 18, 2021) “3 Tax Penalties That Can Ding Your Retirement Accounts”

 

Sims & Campbell, LLC – Annapolis and Towson Estate Planning Attorneys

Estate Planning Meets Tax Planning – Annapolis and Towson Estate Planning

Not keeping a close eye on tax implications, often costs families tens of thousands of dollars or more, according to a recent article from Forbes, “Who Gets What—A Guide To Tax-Savvy Charitable Bequests.” The smartest solution for donations or inheritances is to consider your wishes, then use a laser-focus on the tax implications to each future recipient.

After the SECURE Act destroyed the stretch IRA strategy, heirs now have to pay income taxes on the IRA they receive within ten years of your passing. An inherited Roth IRA has an advantage in that it can continue to grow for ten more years after your death, and then be withdrawn tax free. After-tax dollars and life insurance proceeds are generally not subject to income taxes. However, all of these different inheritances will have tax consequences for your beneficiary.

What if your beneficiary is a tax-exempt charity?

Charities recognized by the IRS as being tax exempt do not care what form your donation takes. They do not have to pay taxes on any donations. Bequests of traditional IRAs, Roth IRAs, after-tax dollars, or life insurance are all equally welcome.

However, your heirs will face different tax implications, depending upon the type of assets they receive.

Let’s say you want to leave $100,000 to charity after you and your spouse die. You both have traditional IRAs and some after-tax dollars. For this example, let’s say your child is in the 24% tax bracket. Most estate plans instruct charitable bequests be made from after-tax funds, which are usually in the will or given through a revocable trust. Remember, your will cannot control the disposition of the IRAs or retirement plans, unless it is the designated beneficiary.

By naming a charity as a beneficiary in a will or trust, the money will be after-tax. The charity gets $100,000.

If you leave $100,000 to the charity through a traditional IRA and/or your retirement plan beneficiary designation, the charity still gets $100,000.

If your heirs received that amount, they would have to pay taxes on it—in this example, $24,000. If they live in a state that taxes inherited IRAs or if they are in a higher tax bracket, their share of the $100,000 is even less. However, you have options.

Here is one way to accomplish this. Let’s say you leave $100,000 to charity through your IRA beneficiary designations and $100,000 to your heirs through a will or revocable trust. The charity receives $100,000 and pays no tax. Your heirs also receive $100,000 and pay no federal tax.

A simple switch of who gets what saves your heirs $24,000 in taxes. That is a welcome savings for your heirs, while the charity receives the same amount you wanted.

When considering who gets what in your estate plan, consider how the bequests are being given and what the tax implications will be. Talk with your estate planning attorney about structuring your estate plan with an eye to tax planning.

Reference: Forbes (Jan. 26, 2021) “Who Gets What—A Guide To Tax-Savvy Charitable Bequests”

 

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How to Make Beneficiary Designations Better – Annapolis and Towson Estate Planning

Beneficiary designations supersede all other estate planning documents, so getting them right makes an important difference in achieving your estate plan goals. Mistakes with beneficiary designations can undo even the best plan, says a recent article “5 Retirement Plan Beneficiary Mistakes to Avoid” from The Street. Periodically reviewing beneficiary forms, including confirming the names in writing with plan providers for workplace plans and IRA custodians, is important.

Post-death changes, if they can be made (which is rare), are expensive and generally involve litigation or private letter rulings from the IRS. Avoiding these five commonly made mistakes is a better way to go.

1—Neglecting to name a beneficiary. If no beneficiary is named for a retirement plan, the estate typically becomes the beneficiary. In the case of IRAs, language in the custodial agreement will determine who gets the assets. The distribution of the retirement plan is accelerated, which means that the assets may need to be completely withdrawn in as little as five years, if death occurs before the decedent’s required beginning date for taking required minimum distributions (RMDs).

With no beneficiary named, retirement plans become probate accounts and transferring assets to heirs becomes subject to delays and probate fees. Assets might also be distributed to people you didn’t want to be recipients.

2—Naming the estate as the beneficiary. The same issues occur here, as when no beneficiary is named. The asset’s distributions will be accelerated, and the plan will become a probate account. As a general rule, estates should never be named as a beneficiary.

3—Not naming a spouse as a primary beneficiary. The ability to stretch out the distribution of retirement plans ended when the SECURE Act was passed. It still allows for lifetime distributions, but this only applies to certain people, categorized as “Eligible Designated Beneficiaries” or “EDBs.” This includes surviving spouses, minor children, disabled or special needs individuals, chronically ill people and individuals who are not more than ten years younger than the retirement plan’s owner. If your heirs do not fall into this category, they are subject to a ten-year rule. They have only ten years to withdraw all assets from the account(s).

If your goal is to maximize the distribution period and you are married, the best beneficiary is your spouse. This is also required by law for company plans subject to ERISA, a federal law that governs employee benefits. If you want to select another beneficiary for a workplace plan, your spouse will need to sign a written spousal consent agreement. IRAs are not subject to ERISA and there is no requirement to name your spouse as a beneficiary.

4—Not naming contingent beneficiaries. Without contingency, or “backup beneficiaries,” you risk having assets being payable to your estate, if the primary beneficiaries predecease you. Those assets will become part of your probate estate and your wishes about who receives the asset may not be fulfilled.

5—Failure to revise beneficiaries when life changes occur. Beneficiary designations should be checked whenever there is a review of the estate plan and as life changes take place. This is especially true in the case of a divorce or separation.

Any account that permits a beneficiary to be named should have paperwork completed, reviewed periodically and revised. This includes life insurance and annuity beneficiary forms, trust documents and pre-or post-nuptial agreements.

Reference: The Street (Aug. 11, 2020) “5 Retirement Plan Beneficiary Mistakes to Avoid”

 

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Is there a Better Plan than a Reverse Mortgage? – Annapolis and Towson Estate Planning

If you are 62 or older, one way to get a bit more cash, is to use the equity in your home in a reverse mortgage. It is a type of loan that allows you to borrow against the equity in your home and receive a set monthly payment or line of credit (or a combination of the two). The repayment is deferred until you move out, sell the home, become delinquent on property taxes or insurance, the home falls into disrepair, or you pass away. At that point, the house is sold and any excess funds after repayment belong to you or your heirs.

Investopedia’s recent article entitled “Alternatives to a Reverse Mortgage” explains that reverse mortgages can be troublesome, if you do not set it up right. They also require careful consideration for the rights of the surviving spouse, if you are married. Ultimately, with a reverse mortgage, you or your heirs give up your home, unless you are able to buy it back from the bank. There are some less than stellar reverse mortgage companies out there, so it can be risky.

There are a few other ways to generate cash for your living expenses in retirement.

Refinance Your Mortgage. You may be able to refinance your existing mortgage to lower your monthly payments and free up some cash. It is wise to lower the interest rate on your mortgage, which can save you money over the life of the loan, decrease the size of your monthly payments and help you build equity in your home more quickly. If you refinance rather than going with a reverse mortgage, your home remains as an asset for you and your heirs.

Get a Home-Equity Loan. This loan or second mortgage allows you to borrow money against the equity in your home. Note that the new Tax Cuts and Jobs Act restricted the eligibility for a home-equity loan interest deduction. For tax years 2018 through 2025, you will not be able to deduct home-equity loan interest, unless the loan is used specifically for qualified purposes. Like refinancing, your home remains an asset for you and your heirs. Remember that because your home is collateral, there is a risk of foreclosure, if you default on the loan.

Use a Home Equity Line of Credit. A home-equity line of credit (HELOC) lets you borrow up to your approved credit limit on an as-needed basis. Unlike a home-equity loan, where you pay interest on the entire loan amount whether you are using the money or not, with a HELOC you pay interest only on the amount of money you actually take out. These are adjustable loans, so your monthly payment will change with fluctuating interest rates.

Downsize. The options previously discussed let you keep your existing home. However, if you are willing and able to move, selling your home allows you to tap into your equity. Many people downsize, because they are in a home that is much larger than they need without children around. Your current home also may be too difficult or costly to maintain. When you sell, you can use the proceeds to purchase a smaller, more affordable home or you might just rent, and you will have extra money to save, invest or spend as you want.

Sell Your Home to Your Children. Another alternative to a reverse mortgage, is to sell your home to your children. You might think about a sale-leaseback. In this situation, you would sell the house, then rent it back using the cash from the sale. As landlords, your children get rental income and can take deductions for depreciation, real estate taxes and maintenance. You could also consider a private reverse mortgage. This works like a reverse mortgage, except the interest and fees stay in the family: your children make regular payments to you, and when it is time to sell the house, they recoup their contributions (and interest).

Reverse mortgages may be a decent option for people who are house rich and cash poor, with lots of home equity but not enough income for retirement. However, this article lays out some other options, that let you to tap into the equity you have built up in your home. Before making any decisions, do some research on your options, shop around for the best rates (where applicable) and speak with an experienced elder law attorney.

Reference: Investopedia (June 25, 2020) “Alternatives to a Reverse Mortgage”

 

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Do I Qualify as an Eligible Designated Beneficiary under the SECURE Act? – Annapolis and Towson Estate Planning

An eligible designated beneficiary (EDB) is a person included in a unique classification of retirement account beneficiaries. A person may be classified as an EDB, if they are classified as fitting into one of five categories of individuals identified in the Setting Every Community Up for Retirement Enhancement (SECURE) Act. The bill passed in December 2019 and is effective for all inherited retirement accounts, as of the first of this year.

Investopedia’s recent article entitled “Eligible Designated Beneficiary” explains that these people get special treatment and greater flexibility to withdraw funds from their inherited accounts than other beneficiaries.

With the SECURE Act, there are now three types of beneficiaries. It is based on the individual’s connection to the original account owner, the beneficiary’s age, and his or her status as either an individual or a non-person entity. However, an EDB is always an individual. On the other hand, an EDB cannot be a trust, an estate, or a charity, which are considered not designated beneficiaries. There are five categories of individuals included in the EDB classification. These are detailed below.

In most instances, except for the exceptions below, an EDB must withdraw the balance from the inherited IRA account over the beneficiary’s life expectancy. There is optional special treatment allowed only for surviving spouses, which is explained below. When a minor child reaches the age of majority, he or she is no longer considered to be an EDB, and the 10-year rule concerning withdrawal requirements for a designated beneficiary applies.

Here are the five categories of EDBs.

Owner’s surviving spouse. Surviving spouses get special treatment, which lets them step into the shoes of the owner and withdraw the balance from the IRA over the original owner’s life expectancy. As another option, they can roll an inherited IRA into their own IRA and take withdrawals at the point when they would normally take their own required minimum distributions (RMDs).

Owner’s minor child. A child who is not yet 18 can make withdrawals from an inherited retirement account using their own life expectancy. However, when he or she turns 18, the 10-year rule for designated beneficiaries (who are not EDBs) applies. At that point, the child would have until December 31 of the 10th year after their 18th birthday to withdraw all funds from the inherited retirement account. A deceased retirement account owner’s minor child can get an extension, up until age 26, for the start of the 10-year rule, if he or she is pursuing a specified course of education.

An individual who is disabled. The tax code says that an individual is considered to be disabled if he or she is “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long continued and indefinite duration.” A disabled person who inherits a retirement account can use their own life expectancy to calculate RMDs.

An individual who is chronically ill. The tax code states that “the term ‘chronically ill individual’ means any individual who has been certified by a licensed healthcare practitioner as—

  • being unable to perform (without substantial assistance from another individual) at least two activities of daily living for a period of at least 90 days, due to a loss of functional capacity,
  • having a level of disability similar (as determined under regulations prescribed by the Secretary in consultation with the Secretary of Health and Human Services) to the level of disability described in clause (i), or
  • requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment.”

A chronically ill individual who inherits a retirement account can use their own life expectancy to determine the RMDs.

Any other person who is less than 10 years younger than the decedent. This is a catch-all that includes certain friends and siblings (depending on age), who are identified as beneficiaries of a retirement account. This also excludes most adult children (who are not disabled or chronically ill) from the five categories of EDBs. A person in this category who inherits a retirement account is permitted to use their own life expectancy to calculate RMDs.

Reference: Investopedia (June 25, 2020) “Eligible Designated Beneficiary”

 

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Should I Borrow from my 401(k) during the Pandemic? – Annapolis and Towson Estate Planning

The major advantage of saving in a 401(k), is that you can have tax-deferred growth on your investments. When you are saving money for the long term, you typically want to leave it alone. However, there are some situations, in which withdrawing money from your 401(k) is acceptable.

Investopedia’s recent article entitled “Hardship Withdrawal vs. 401(k) Loan: What’s the Difference?” says that prior to making a move, you need to understand the financial implications of using your retirement plan early. There are two basic ways to take money out before reaching retirement age.

One option is to take a hardship withdrawal. The IRS says that hardship withdrawals are okay, only when there is an immediate and great financial need. These withdrawals are usually limited to the amount required to satisfy that need. These withdrawals are subject to ordinary income tax and, if you are not yet 59½, there is a 10% early withdrawal penalty, except if you are impacted by the COVID-19 pandemic. The CARES Act lets you make a penalty-free COVID-19 related withdrawal or take out a loan from your 401(k) in 2020, with special repayment provisions and tax treatment.

The IRS has a safe harbor exception that lets you automatically meet the heavy-need standard in certain situations, such as for those who must take a hardship withdrawal to pay for medical expenses for themselves, a spouse, or dependents. A hardship withdrawal could also be helpful, if you are in a long period of unemployment and do not have an emergency fund. The IRS waives the penalty if you are unemployed and need to buy health insurance, but you would still owe taxes on the withdrawal. Other situations that are covered by the safe harbor exception include:

  • Tuition, education fees, and room-and-board expenses for the next 12 months of post-secondary school for the employee or the employee’s spouse, children, dependents, or beneficiary.
  • Payments that are required to prevent the eviction of the employee from his or her principal residence or foreclosure on the mortgage on that residence.
  • Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
  • Certain expenses to repair damage to the employee’s principal residence.

If you qualify for a Coronavirus-Related Distribution (CRD) from your 401(k) plan during 2020, that distribution will be treated as a safe-harbor distribution that is not subject to a 10% early withdrawal penalty if you are under 59½ but subject to regular income taxes. Some other unique stipulations to this special distribution say that:

  • You can withdraw up to $100,000 or your account balance, whichever is less.
  • You can spread out any taxes over three years.
  • If you pay the funds back into your account within three years, it will be considered a rollover and not taxed.

The IRS has expanded the eligibility for a hardship withdrawal to include having a job start date delayed or a job offer rescinded because of COVID-19 and allow a spouse of an impacted person to make a hardship withdrawal—even if the spouse is still working.

If you are not in such a financial state but still want to take cash from your plan, a 401(k) loan is the other way to go. The IRS says that you can borrow 50% of your vested account balance or $50,000, whichever is less. However, a loan has both pros and cons. You are in effect paying back the money to yourself. That means you are returning it to your retirement account, and that is good. However, if you leave your job and do not repay the loan within a specified period (which was recently extended to the due date of your federal income tax return, instead of the previous 60-to-90 day window, under the Tax Cuts and Jobs Act), it is treated as a regular distribution. Therefore, income tax and the early withdrawal penalty would apply.

However, there may be situations in which you might consider a loan. New rules also let you withdraw a loan of up to $100,000 or the amount in your employer-sponsored retirement plan (whichever is less) anytime until September 23, 2020, and delay payments on the loan for up to a year (but the interest will accrue.) If you already have an outstanding loan, the payments can also be deferred for a year.

Consolidating debt. You could use the loan to consolidate high-interest debt, if your credit doesn’t qualify you for a low rate on a personal loan or a debt consolidation loan.

Purchasing a home. It could help when you are planning to buy a home. You could use the money to cover closing costs or hold it in your down-payment savings account for a few months before buying. A 401(k) loan typically must be repaid within five years with at least quarterly payments, but the IRS allows provisions for plan administrators to extend the repayment period longer for those buying a home.

Making an Investment. You could make an investment, like a home as an investment property when you plan to renovate the home and flip it for a profit but need capital to make the purchase.

When You Have A Comfortable Retirement Cushion. If you have been saving regularly for many years with solid investments, you may be ahead of schedule when it comes to hitting your retirement goal. If so, and your job is stable, taking a loan from your 401(k) may not be too bad for your retirement.

There is also an option for 2020 only for taking a 401(k) loan. If you qualify for a CRD, the CARES Act lets you to take a loan of up to $100,000 or the amount in your employer-sponsored retirement plan (whichever is less) until September 23, 2020. You can postpone the payments for up to a year, but interest will accrue. If you already have an outstanding loan, those payments can also be deferred for a year.

If you decide to take a loan or a hardship withdrawal, be certain that you understand the potential tax consequences of doing so.

Reference: Investopedia (June 23, 2020) “Hardship Withdrawal vs. 401(k) Loan: What’s the Difference?”

 

Sims & Campbell, LLC – Annapolis and Towson Estate Planning Attorneys