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Tapping Retirement Savings During the COVID-19 Financial Crisis

As the number of COVID-19 cases began to skyrocket in March 2020, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The legislation may make it easier for Americans to access money in their retirement plans, temporarily waiving the 10% early-withdrawal penalty and increasing the amount they could borrow. Understanding these new guidelines and the other rules for loans and early withdrawals may help you determine if they are appropriate options during a financial crisis. (Remember that tapping retirement savings now could risk your financial situation in the future.)

Penalty-Free Withdrawals

The newest exception to the 10% early-withdrawal penalty allows IRA account holders and retirement plan participants to take distributions of up to $100,000 in 2020 for a “coronavirus-related” reason.* These situations include a diagnosis of COVID-19 for account owners and certain family members; a financial setback due to a quarantine, furlough, layoff, or reduced work hours, and in the case of business owners, due to closures or reduced hours; or an inability to work due to lack of child care as a result of the virus. This temporary exception augments the other circumstances for which a penalty-free distribution is typically allowed:

  • Death or disability of the account owner
  • Unreimbursed medical expenses exceeding 7.5% of adjusted gross income (increases to 10% in 2021)
  • A series of “substantially equal periodic payments” over your life expectancy or the joint life expectancy of you and your spouse
  • Birth or adoption of a child, up to $5,000 per account owner
  • Certain cases when military reservists are called to active duty

In addition, IRAs (but not work-based plans) allow penalty-free withdrawals for a first-time home purchase ($10,000 lifetime limit), qualified higher-education expenses, and payments of health insurance premiums in the event of a layoff.

Five Industries Most Likely to Offer Retirement Plan Loans
Percentage of plans that offer loans, by type of industry3

Work-based plans allow exceptions for those who separate from service after age 55 (50 in the case of qualified public safety employees) and distributions as part of a qualified domestic relations order.

Tax Consequences

Penalty-free does not mean tax-free, however. In most cases, when you take a penalty-free distribution, you must report the full amount of the distribution on your income tax return for that year. However, the income associated with a coronavirus-related distribution can be spread over three years for tax purposes, with up to three years to reinvest the money.1

Retirement Plan Loans

If your work-based retirement plan allows loans, you typically can borrow up to the lesser of 50% of your vested balance or $50,000. Most loans must be repaid within five years, but if the money is used to purchase a primary residence, the repayment period may be longer. The CARES Act permits employers to increase this amount to the lesser of 100% of the vested balance or $100,000 for loans to coronavirus-affected individuals made between March 27, 2020, and September 22, 2020.* Affected participants who have outstanding loans on or after March 27, 2020, will be able to delay any payments due in 2020 by one year.2

Hardship Withdrawals

Many work-based retirement plans also permit hardship withdrawals in certain circumstances. Although these distributions are not exempt from the 10% early-withdrawal penalty, they can be a lifeline for people who need money in an emergency.

For more information about your options, contact your IRA or retirement plan administrator.

*Employers do not have to adopt the new withdrawal and loan provisions.

  1. Amounts reinvested may reduce your tax obligation on the distributions; however, due to the timing of distributions and required tax filings, you may have to file an amended return to seek a refund on any taxes previously paid on withdrawn amounts.
  2. The original five-year repayment period will be extended for the delay, but interest will continue to accrue.
  3. Source: Plan Sponsor Council of America, 2019 (2018 data)
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July 15 Due Date Approaches for 2019 Federal Income Tax Returns and Payments

The due date for federal income tax returns and payments for the 2019 tax year is Wednesday, July 15, 2020. Due to the coronavirus pandemic, the original due date for filing federal income tax returns and making tax payments was postponed by the IRS from April 15, 2020, to July 15, 2020. No interest, penalties, or additions to tax are incurred by taxpayers during this 90-day relief period for any return or payment postponed under this relief provision.

The relief applied automatically to all taxpayers, who did not need to file any additional forms to qualify for the relief. The relief applied to federal income tax payments (for taxable year 2019) due on April 15, 2020, and estimated tax payments (for taxable year 2020) due on April 15, 2020, and June 15, 2020, including payments of tax on self-employment income. There is no limit on the amount of tax that could be deferred.

Need more time?

If you’re not able to file your federal income tax return by July 15, you can file for an extension by the July due date using IRS Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return. Filing this extension gives you an additional three months (until October 15, 2020) to file your federal income tax return. You can also file for an automatic three-month extension electronically (details on how to do so can be found in the Form 4868 instructions).

Pay what you owe

One of the biggest mistakes you can make is not filing your return because you owe money. If the bottom line on your return shows that you owe tax, file and pay the amount due in full by the due date if at all possible. If you absolutely cannot pay what you owe, file the return and pay as much as you can afford. You’ll owe interest and possibly penalties on the unpaid tax, but you will limit the penalties assessed by filing your return on time, and you may be able to work with the IRS to pay the unpaid balance (options available may include the ability to enter into an installment agreement).

It’s important to understand that filing for an automatic extension to file your return does not provide any additional time to pay your tax. When you file for an extension, you have to estimate the amount of tax you will owe; you should pay this amount by the July due date. If you don’t, you will owe interest, and you may owe penalties as well. If the IRS believes that your estimate of taxes was not reasonable, it may void your extension.

Tax refunds

The IRS encourages taxpayers seeking a tax refund to file their tax return as soon as possible. Apparently, most tax refunds are still being issued within 21 days of the IRS receiving a tax return. However, the IRS is experiencing delays in processing paper tax returns due to limited staffing.

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Social Security and Medicare Face Financial Challenges

Most Americans will receive Social Security and Medicare benefits at some point in their life. Every year, the Trustees of the Social Security and Medicare Trust Funds release lengthy reports to Congress assessing the health of these important programs.  The newest reports, released April 22, 2020, discuss the current financial condition and ongoing financial challenges both programs face.

How Social Security and Medicare will be affected by the COVID-19 pandemic is still uncertain; the Trustees acknowledge that the estimates and analysis included in the reports do not reflect the potential side-effects of lower social security and medicare tax receipt due to the large number of people experiencing job losses or decreases in working hour and wages due to the state shutdowns.

Social Security Trust Funds

The Social Security program consists of two parts, each with its own financial account (trust fund) that holds the Social Security payroll taxes collected from current workers to pay Social Security benefits. It’s important to remember that Social Security is a system built on taxing the payrolls of employers (and employees themselves) and these taxes collected from current workers goes to pay for beneficiary recipients. Retired workers, their families, and survivors of workers receive monthly benefits under the Old-Age and Survivors Insurance (OASI) program; disabled workers and their families receive monthly benefits under the Disability Insurance (DI) program.

The combined programs are referred to as OASDI. Other income (reimbursements from the General Fund of the U.S. Treasury and income tax revenue from benefit taxation) is also deposited in these accounts. Money that is not needed in the current year to pay benefits and administrative costs is invested (by law) in special Treasury bonds that are guaranteed by the U.S. government and earn interest. As a result, the Social Security Trust Funds have built up reserves that can be used to cover benefit obligations if payroll tax income is insufficient to pay full benefits.

Note that the Trustees provide certain projections based on the combined OASI and DI (OASDI) Trust Funds. However, these projections are hypothetical, because the trusts are separate, and generally one program’s taxes and reserves cannot be used to fund the other program.

Highlights of the Social Security Trustees Report

  • Social Security’s total cost is projected to be less than its total income in 2020 and higher than its total income (including interest) in 2021 and all later years. The U.S. Treasury will need to withdraw from trust fund reserves to help pay benefits. The Trustees project that the hypothetical combined trust fund reserves (OASDI)  will be depleted in 2035, the same as projected in last year’s report, unless Congress acts.
  • Once the hypothetical combined trust fund reserves are depleted in 2035, payroll tax revenue alone should still be sufficient to pay about 79% of scheduled benefits initially, with the percentage falling gradually to 73% by 2094.
  • The OASI Trust Fund, when considered separately, is projected to be depleted in 2034, the same as projected in last year’s report. Payroll tax revenue alone would then be sufficient to pay  76% of scheduled benefits.
  • The DI Trust Fund is expected to be depleted in 2065,  13 years later than projected in last year’s report. For a second year in a row, the depletion date has changed significantly, reflecting the fact that both benefit applications and the total number of disabled workers currently receiving benefits have been declining over the past few years. Once the DI Trust Fund is depleted, payroll tax revenue alone would be sufficient to pay 92% of scheduled benefits.
  • Based on the “intermediate” assumptions in this year’s report, the Social Security Administration is projecting that the cost-of-living adjustment (COLA), which will be announced in the fall of 2020, will be 2.3% (last year’s report projected a COLA of 1.8% and the actual COLA was 1.6%). This COLA would apply to benefits starting in January 2021.

Medicare Trust Funds

There are two Medicare trust funds. The Hospital Insurance (HI) Trust Fund helps pay for hospital care (Medicare Part A costs). The Supplementary Medical Insurance (SMI) Trust Fund comprises two separate accounts, one covering Medicare Part B (which helps pay for physician and outpatient costs) and one covering Medicare Part D (which helps cover the prescription drug benefit).

Highlights of the Medicare Trustees Report

  • Annual costs for the Medicare HI Trust Fund exceeded tax income each year from 2008 to 2015. There were small fund surpluses in 2016 and 2017. In 2018 and 2019, expenditures exceeded income, and deficits are expected for all later years.
  • The HI Trust Fund is projected to be depleted in 2026, the same year as projected in last year’s report. Once the HI Trust Fund is depleted, tax and premium income would still cover 90% of estimated program costs, declining to 78% by 2044 and then gradually increasing to 90% by 2094. The  Trustees note that long-range projections of Medicare costs are highly uncertain because the health-care landscape is shifting and the effects are unknown.

Why are Social Security and Medicare Facing Financial Challenges?

Social Security and Medicare are funded primarily through the collection of payroll taxes. Because of demographic and economic factors, including higher retirement rates and lower birth rates, there will be fewer workers per beneficiary over the long term, worsening the strain on the trust funds.

What is Being Done to Address These Challenges?

Both reports continue to urge Congress to address the financial challenges facing these programs soon, so that solutions will be less drastic and may be implemented gradually, lessening the impact on the public. Combining some of the following solutions may also lessen the impact of any one solution.

  • Raising the current Social Security payroll tax rate (currently 12.40%).  According to this year’s report, an immediate and permanent payroll tax increase of 3.14 percentage points to 15.54%  would be necessary to address the long-range revenue shortfall (4.13 percentage points to 16.53% if the increase started in 2035).
  • Raising or eliminating the ceiling on wages currently subject to Social Security payroll taxes ($137,700 in 2020).
  • Raising the full retirement age beyond the currently scheduled age of 67 (for anyone born in 1960 or later).
  • Reducing future benefits. According to this year’s report, to address the long-term revenue shortfall, scheduled benefits would have to be immediately and permanently reduced by about 19% for all current and future beneficiaries, or by about 23% if reductions were applied only to those who initially become eligible for benefits in 2020 or later.
  • Changing the benefit formula that is used to calculate benefits.
  • Calculating the annual cost-of-living adjustment for benefits differently.

You can view a combined summary of the 2020 Social Security and Medicare Trustees Reports and a full copy of the Social Security report at ssa.gov.  You can find the full Medicare report at cms.gov.

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